Stocks and Bonds Move Higher Amid a Volatile Month
- A couple regional bank failures sent concern through the market and volatility surged to its highest level of 2023. However, those events appeared more isolated, and stocks rallied in the second half of the month as volatility fell.
- The VIX Index, a measure of volatility, rose to just below 30 on an intraday basis in mid-March, but it moved steadily lower from that point and closed March at 18.70. That compares to a close of 20.70 at the end of February.
- Treasuries rallied and yields moved lower for most of March in a flight to quality. The 10-year U.S. Treasury yield crept above 4% in early March (closing at 4.08% on March 2) only to move lower from that point. It closed March at 3.48% and declining rates set up a solid backdrop for bond returns.
- The FOMC raised rates by 0.25% at its late March meeting as expected. However, it appears the Fed might be on hold following this meeting as it assesses incoming economic data as well as monitoring any banking issues that might yet appear.
- Economic data continued to be mixed but the job market remained strong. Furthermore, inflation data, which had negatively surprised to the upside in January, moderated in February as progress continues to be made on this front.
As March progressed, a trend developed in the equity markets – large-cap growth companies moved into a leadership role and outperformed other areas of the stock market. Small-cap companies struggled as did more value-focused stocks. With volatility levels elevated, equity investors favored mega-cap technology companies with perceived strong balance sheets and solid cash flow characteristics. This resulted in a recovery in some pockets of equities in March, but other areas lagged. See Table 1 for equity results for March and the first quarter.
|Index||February 2023||Q1 2023|
|S&P 500 Equal Weight||-0.88%||2.93%|
|MSCI ACWI ex U.S.||2.44%||6.87%|
|MSCI Emerging Mkts Net||3.03%||3.96%|
For example, the S&P 500 Index posted a solid gain of 3.67% in March, but looking at the S&P 500 on an equal-weighted basis showed the average stock was actually lower by -0.88%. Recall the S&P 500 Index is a market-cap weighted index and is becoming more and more dominated by mega-cap Technology companies and those stocks are the primary driver of this index’s returns.
More to this point, the broader market struggled as a handful of mega-cap Technology names rallied. The NASDAQ Composite stood out with the best results in March given its heavy exposure to Technology. Meanwhile, the Russell 2000 Index, a measure of small-cap companies, struggled in March owing much of that weakness to regional banks that are found in this index. International stocks fared well in March as the broader measure of international stocks, the MSCI ACWI ex U.S. Index, advanced along with emerging markets during the month.
On a year-to-date basis, significant divergences existed in the stock market. The theme that developed in the first quarter was the outperformance of large-cap growth stocks. The Russell 1000 Growth Index gained 6.84% for the month and was up 14.37% for the quarter. By contrast, the Russell 1000 Value Index declined -0.46% in March and gained a mere 1.01% during the first quarter. The decline in small-caps in March wiped out much of their quarterly gain with growth outperforming value in this space as well.
After rising dramatically in February, the decline in rates was equally dramatic in March and bonds benefitted from this move lower in yields. As volatility mounted in the stock market, there was a flight to quality that drove Treasury yields down in March. The 10-year U.S. Treasury closed February at 3.92%, but by March’s end, the yield had dropped to 3.48%.
The more interest-rate sensitive parts of the bond market, like U.S. Treasuries, produced the strongest gains in fixed income in March, but bonds across most sectors advanced during the month. For example, a significant portion of the quarterly gains for the Treasury indices came from the returns in March. On the contrary, high yield bonds had the most modest gains for the month, but still showed some of the best results for the quarter due to progress made in January and February. Please see Table 2 for fixed income returns for March and the first quarter.
|Bloomberg U.S. Agg||2.54%||2.96%|
|Bloomberg U.S. Credit||2.74%||3.45%|
|Bloomberg U.S. High Yld||1.07%||3.57%|
|Bloomberg 30-year U.S. TSY||4.55%||5.99%|
|Bloomberg U.S. TSY||2.89%||3.01%|
We believe the move higher in rates in 2022 has largely run its course at the longer end of the yield curve and we expect the 10-year yield to move lower as we go through 2023. While volatile, that has occurred so far in 2023 with longer-dated yields declining, which we believe has set up a better return environment for bonds.
In previous Fed rate hike cycles, longer rates have started to come down before the Fed has stopped raising the Federal Funds rate and that pattern has played out this year as well. The situation with the regional banks and ongoing progress on inflation seems to be giving the Fed plenty of cover to pause its rate hikes. If not the ninth inning, we maintain our opinion that we are in the late innings of this rate hike cycle. We maintain our long-standing position favoring credit versus pure rate exposure in this interest rate environment. We also believe that the role bonds play in a portfolio, to provide stable cash flows and to help offset the volatility of stocks in the long run, has not changed.
Economic Data and Outlook
The economic momentum enjoyed by the U.S. economy in the second half of 2022 continued, as we expected, in early 2023. In February, non-farm payrolls advanced by 311,000 – once again surpassing estimates of 225,000. Although the unemployment rate unexpectedly rose to 3.6% when expectations were calling for it to remain at 3.4%, the labor force participation rate ticked higher when it was expected to show no growth. Chart 1 shows that the labor force participation rate has been steadily declining for years (driven in large part by baby boomers retiring), but the large drop because of the pandemic has started to steadily improve and is getting closer to pre-pandemic levels.
More people returning to the labor force would help the mismatch in job seekers versus job openings with millions more open jobs than people looking for work. The JOLTS reading on job openings surprised to the upside in January. Over 10.8 million job openings were reported in January, when just over 10.5 million openings were expected. The revised December mark showed more job openings than originally estimated at over 11.2 million.
Wages climbed by 4.6% on an annual basis, which was below expectations of 4.7%, but still higher than the prior month of 4.4%. The Fed aggressively raising rates over the last year is expected to raise unemployment, but Fed rate increases so far have not resulted in significant weakness in the job market outside of the tech sector. The Fed will likely watch job market data closely because readings that are too strong (in their opinion) could be viewed as inflationary and lead to additional rate hikes.
Housing continues to be impacted by changes in interest rates due to the direct impact on mortgage rates. Interest rates have been volatile this year and housing activity was largely better than expected in February. Building permits, considered a leading indicator for housing, surged in February at an annualized pace of 1.524 million. That compares to estimates of 1.342 million and the prior month’s level of 1.339 million. Furthermore, housing starts rose to a 1.45 million annual rate – easily surpassing estimates of 1.31 million and the prior month’s level of 1.321 million. Chart 2 shows the slowing trend in housing activity, but the bounce back in permits and starts in February.
Existing home sales surpassed estimates as well at a 4.58 million pace when a reading of only 4.2 million was anticipated.
New home sales stood out as the only housing reading below estimates (640K versus 650K) but that was even better than the prior month of 633K. Housing prices continued to decline on a monthly basis but based on the S&P CoreLogic CS 20-City Index, home prices rose by 2.55% on an annual basis in January. Home prices have continued to decline over the last several months as mortgage rates have increased dramatically over the last year.
The ISM Manufacturing Index showed contraction for the 4th consecutive month in February with a reading of 47.7 – a modest improvement from January’s reading of 47.4, but below expectations of 48.0. (The reading for March marked a 5th straight month of contraction at 46.3 – the lowest level since May 2020.) The ISM Non-Manufacturing Index, which covers the much larger service industries in the U.S. economy, continued to show solid expansion with a reading of 55.1 in February – better than expectations of 54.5 and just modestly lower than the 55.2 mark from January. Recall that ISM readings above 50 indicate expansion and below 50 signal contraction.
Retail sales (ex. auto and gas) were flat in February when a -0.2% drop was anticipated. The prior month’s spending was revised higher by 0.2% to a 2.8% monthly increase. It is important to note that retail sales data is not inflation adjusted, so higher prices can drive stronger spending activity. The preliminary University of Michigan Sentiment reading for March dropped to 63.4 from the prior month’s mark and expectations of 67.0.
The Conference Board’s Leading Index continued to decline and fell by -0.3% in February as expected. The third and final reading of Q4 2022 GDP came in at a 2.6% annualized pace of growth, which was a slight decline from the prior estimate (and expectations) of 2.7%. The U.S. economy weakened in the first half of 2022, but it rebounded in the second half of the year and that economic momentum has continued into the first part of 2023. However, we expect growth to slow down later in the year and we acknowledge the risk of a mild recession has increased and we believe it is about as likely as a soft landing.
After disappointing January inflation data hit the market in February, inflation readings covering February, released in March were largely positive. The headline Consumer Price Index for February dropped to 6.0% as expected from 6.4%. The headline Producer Price Index fell to a 4.6% annual increase, which was much better than expectations of 5.4% and the prior month’s mark of 5.7%. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures Index, dropped to 5.0% in February from a revised lower 5.3% in January and this beat expectations of 5.1%. Similarly, the core reading of the PCE Index (the primary way the Fed looks at inflation) showed a monthly increase of 0.3%, which was better than the 0.4% expected and an annual increase of 4.6%, a modest drop from the 4.7% increase from January. Chart 3 shows that the trend for inflation continues lower.
The Fed’s aggressive rate hikes impacted capital markets and the economy last year. Markets reset valuations based on higher interest rates and lower corporate earnings expectations in this rate-tightening cycle. However, we believe we are in the late innings of this rate hike cycle, particularly after the recent issues in some regional banks, which could result in the Fed taking a more cautious approach to additional rate hikes.
Although economic growth picked up in the second half of 2022 and we believe that momentum has continued early in the new year, we expect growth to slow later in 2023 and believe the odds of a mild recession are about 50/50. However, the job market has remained strong and is a critical component of our overall economy, leading us to the conclusion that any economic slowdown would be modest. As always, we believe it is imperative for investors to stay focused on their long-term goals and not let short-term swings in the market derail them from their longer-term objectives.
Clark Capital’s Top-Down, Quantitative Strategies
Our tactical strategies, including Fixed Income Total Return and Global Tactical, were positioned in cash equivalents until mid-March. Our credit-based risk management models shifted toward favoring U.S. Treasuries, which regained relative strength as banking system stability came into question. Those strategies remained positioned defensively in U.S. Treasuries as the quarter ended.
Clark Capital’s Bottom-Up, Fundamental Strategies
The main priority in our fixed income portfolios last month was a focus on credit analysis. In particular, we were focused on ensuring that any banks held in the portfolios were not at risk of failing. Across our equity portfolios, we continue to focus on dividend growers and the quality factors that we believe can contribute to outperformance in the ongoing earnings downgrade cycle. Those factors include return on equity, profitability, earnings growth, and free cash flow.
|ISM Services Index||Feb||54.5||55.1||55.2||—|
|Change in Nonfarm Payrolls||Feb||225k||311k||517k||504k|
|Average Hourly Earnings YoY||Feb||4.70%||4.60%||4.40%||—|
|JOLTS Job Openings||Jan||10546k||10824k||11012k||11234k|
|PPI Final Demand MoM||Feb||0.30%||-0.10%||0.70%||0.30%|
|PPI Final Demand YoY||Feb||5.40%||4.60%||6.00%||5.70%|
|PPI Ex Food and Energy MoM||Feb||0.40%||0.00%||0.50%||0.10%|
|PPI Ex Food and Energy YoY||Feb||5.20%||4.40%||5.40%||5.00%|
|CPI Ex Food and Energy MoM||Feb||0.40%||0.50%||0.40%||—|
|CPI Ex Food and Energy YoY||Feb||5.50%||5.50%||5.60%||—|
|Retail Sales Ex Auto and Gas||Feb||-0.20%||0.00%||2.60%||2.80%|
|Industrial Production MoM||Feb||0.20%||0.00%||0.00%||0.40%|
|New Home Sales||Feb||650k||640k||670k||633k|
|Existing Home Sales||Feb||4.20m||4.58m||4.00m||—|
|Durable Goods Orders||Feb P||0.20%||-1.00%||-4.50%||-5.00%|
|GDP Annualized QoQ||4Q T||2.70%||2.60%||2.70%||—|
|U. of Mich. Sentiment||Mar P||67||63.4||67||—|
|S&P CoreLogic CS 20-City YoY NSA||Jan||2.60%||2.55%||4.65%||4.62%|
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