Transcript:
Hello, everyone, and thank you for joining us. In a welcome departure from 2022, first-quarter returns across the board were positive for the capital markets despite meaningful volatility. We saw a continued outperformance by international stocks versus the US and positive returns for fixed income, as investors anticipate that the Federal Reserve is nearing the end of its rate hiking cycle.
One component of that volatility was the stress that surfaced in the banking industry. Many investors arguably believe that this concern will be contained, but we feel a degree of caution here is warranted. And while banks’ willingness to lend have been declining even before this news came to light, our view is that lending activity will continue to moderate, therefore making the Fed’s goal of attaining lower inflation and slower economic growth a little easier. But there remains a difference of opinion over what the Fed has been signaling and what the market thinks they will do regarding interest rates.
The market’s expectations look to interest rates easing sooner than the Fed, but the bottom line is that the Fed would rather err on a side of caution versus easing too soon and wind up with bigger inflationary problems down the road. Now, inflation has been trending lower from its peak levels, which is good, but there’s more to the story considering that key areas such as transportation—think auto rentals and repair—and recreation services—which can include anything from cable TV bills to concert tickets—remain at high levels. Beyond inflation, the Fed also remains focused on the labor market, which is still running hot as more people continue to join the labor force at levels well above pre-COVID hiring.
However, one indicator that the labor issue may be cooling is that wage growth is trending lower. With all this in mind we see a mild recession in the US for this year, and modest to tepid growth around the globe, with the exception of China. Looking out to next year, we see economic growth and inflation coming more back to trend, which leads us to the notion that investors should still see quality among the vast array of equities.
During this past quarter, only 10 names delivered 90% of the S&P’s total returns, but we don’t believe this narrow advance will be sustained because many mega-cap stocks now are trading at expensive levels relative to the broader market. We feel quality will be paramount as a year advances, which runs counter to what occurred in some segments of the market in the first quarter. Some low-quality stocks actually perform quite well, such as non-profitable technology companies. But when concerns over economic growth became top of mind midway through the quarter, these stocks lack meaningfully, and earnings upside surprises are low and are likely to remain under pressure as tighter financial conditions and slower economic growth take hold.
One area beyond US large-cap stocks to consider is international equities. China’s reopening, the world’s economic transition to a post-COVID era and a weaker US dollar all then support to international stocks. For example, periods of US-dollar weakness have proven to be a tailwind for this asset class, but return opportunities are not exclusive to equities considering the higher yield environment that has enhanced the return potential for fixed-income investors. One area that continues to look appealing is US high yield, where the current yield to worst—a very good indicator of forward five-year returns—is roughly 8.5%. And high-yield fundamentals are generally on firm ground. For example, interest coverage is at an elevated level, which provides a meaningful degree of comfort that such companies can meet their interest payments on outstanding debt.
Right now, that nearly 8.5% yield to worst is in the upper band of its historical range for US high yield. Other areas that have a favorable risk reward potential in our view are US and global investment-grade credit, and we’re also seeing appealing opportunities in select European and emerging-market bonds. To say the least, there were many crosscurrents and more items that met the eye if one were to casually observe the positive returns tallied in the first quarter. And considering the multitude of unknowns investors are facing, a sound strategy over time has been to take advantage of select well-researched opportunities that may lead to favorable outcomes, especially those opportunities that transcend near-term bouts of market volatility. All the best, and we will see you next quarter.