January 2023 Stonemark Market Commentary

A Year of Transition for Policy and Economies

Inflation remains the focal point for central banks across the world, ranging from the Federal Reserve to the European Central Bank to the Bank of Japan. Tightening measures employed throughout the duration of 2022, primarily raising the discount rate by over 400 basis points, are starting to show signs of bringing prices down. The headline Consumer Price Index (CPI) number has fallen for 4 consecutive months, driven by falling commodity prices coupled with easing supply chain struggles.

Nonetheless, inflation remains too high, and it takes time for tightening to work its way throughout the economy. With headline CPI coming in at 6.4% for the month of December, the Federal Reserve is likely to continue raising rates in the near-term, albeit at a much slower rate. Housing-related inflation remains elevated but will likely begin abating in the next few quarters, but strong wage gains and a record-low unemployment rate are stoking the flames of inflation.

As such, the Federal Reserve has focused on the labor markets as the key component in their ongoing war against inflation. Fed Chair Jerome Powell and the Federal Open Market Committee (FOMC) have expressed their commitment to achieving maximum employment and returning inflation to the rate of 2 percent in the long run. However, inflation and employment are currently at odds with each other, as the strong labor market is proving to be a key component continuing to drive inflation. If jobs reports continue to come in above expectations and the labor market does not show signs of cooling down, the Federal Reserve will continue to raise interest rates in an attempt to slow hiring and wages. With this in mind, the question markets are grappling with is: How long will we be battling inflation in 2023?

According to FactSet, the current market consensus CPI rate for the end of 2023 is sitting at 3.9 percent. Accompanying this consensus forecast, Real GDP Growth consensus for 2023 is near flat at just 0.5 percent. This means that markets are currently pricing a very restrictive and fairly stagnant American economy for 2023. On a global scale, the International Monetary Fund (IMF) sees global growth at 2.9 percent and global inflation at 6.6 percent in 2023.

Ultimately, we see inflation easing enough throughout the duration of 2023 for monetary policy to become less hawkish than it was in 2022. However, 2023 will be a year of transitions, as markets digest higher interest rates than have been seen for the last decade and abating, but still present inflation across the global economy. A return to value after a near decade-long growth bull-run is likely to continue taking place across global markets, and quality in both equity and debt markets will reign supreme amongst a much more restrictive monetary environment.

Stock Quality Matters

With the prospects of lower growth ahead, we believe focusing on strong fundamental and consistent earnings performance will be essential in stock selection throughout 2023. Markets will require strong balance sheets, consistent cash flows, and disciplined capital allocation across all sectors and industries. 2022 was a year of reckoning for growth stocks, causing valuations to correct and offer some enticing entry points. However, it is imperative to be selective with growth stocks in 2023, as profitability and cash flows will be paramount in an environment where there is no cheap capital for expansion. We feel a great way to gain selective exposure to growth in 2023 is through Small Cap value companies, where strong balance sheets, cash flows, and growth prospects are present.

Valuation contraction was the story of 2022 for equity markets; now, as fears pivot to economic recession, earnings move into the spotlight. We will remain vigilant in our research and stock and ETF selection, focusing on equities that have solid earnings, strong balance sheets and products people need in recessionary and inflationary environments. Quality is the key.

New Year – New Leadership

2023 is off to a red-hot start, with the Russell 3000 index returning nearly 7% in January, compared to its near 20% decline in 2022. Risk assets are back in the spotlight amid market speculation of a less-hawkish Federal Reserve and better-than-anticipated economic conditions. Sectors that were the strongest performers in 2022 are the biggest laggards in January, and sectors that were the weakest performers in 2022 were the strongest performers in January.

The start of 2023 is exciting for markets and investors, as broad-based rallies in risk assets charges ahead. However, we urge caution as the underlying fundamental economic conditions remain worrisome, and the Federal Reserve has continued to signal that rates will remain higher for longer. Valuations and profitability will remain a central focus across markets and should remain central in one’s approach to investing.

Income Is Back in the Fixed-Income World

2022 was a unique market, where equity and fixed income markets broke down and fell in tandem. The amalgamation of soaring inflation and unprecedented rate hikes caused equities and fixed income to buck their inverse relationship. Nearly every fixed income sector suffered historic losses, leaving almost nowhere for investors to hide. For bond investors, central banks’ aggressive policy actions have been painful, but the silver lining is that income has returned after a decade of near-zero yields. Yields are up across the bond universe, with many sectors at multiyear highs. These attractive yields and prices within the fixed income markets present an opportunity for investors across the allocation spectrum.

Such high yields might feel abnormal, but the era of near-zero yields that left investors starving for income was an anomaly in broader financial history. We believe that we have returned to an era of structurally higher interest rates, which means investors can now tap into sources of resilient income that have been extremely hard to come by in the recent past. While the path to higher yields was painful, we believe the bulk of rate increases are largely behind us and investors should begin evaluating if fixed income has a place in their portfolio.

Putting it All Together

After the washout that was 2022, central banks forecast slowing their pace of rate increases as they evaluate the impact of prior increases on inflation. As such, investors must be nimble and disciplined amid a tumultuous market that will rely heavily on economic data and corporate earnings. We believe investing in companies with quality core business will effectively position portfolios for long-term resilience. We are particularly looking for companies with high free cash flows, established economies of scale, strong profitability, and a buoyant business model. We see opportunities within the fixed income market, where investors can find consistent income and attractive yields. The trajectory of the economy and subsequent market performance will be dependent upon easing inflation and central bank monetary policy.