iCapital Market Pulse: A Fresh Perspective & Reasons for Optimism

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The market outlooks are out and most everyone is bearish, anticipating weak growth to start the year.  But amid the gloom and having seen the first two weeks of trading in 2023, in this week’s commentary we are focusing on several reasons for optimism. The bottom line is after a reset, this year offers investors a fresh and much better entry point.
 
Yes, we think a growth slowdown and a still aggressive Fed will test the markets in the first half of the year (1H ’23).  However, with inflation showing signs of easing, which should eventually prompt the Fed to stop hiking rates, we see a path for risk assets to recover in the second half of the year (2H ‘23). This means that the time to invest is now – and we would be deliberate and methodical in deploying capital into public and private market opportunities throughout 2023.  
 

Looking Through a Lens of Optimism

With the first two weeks of trading now in the books for 2023, we look ahead and see four key reasons to be optimistic and opportunistic for this year:

1. In our view, the recession or growth slowdown that everyone fears should materialize in the next several quarters and importantly, is increasingly being discounted by the market. Why? Well, to start, consensus expects little to no GDP growth this year already – a big change since September of last year. At the same time, incoming economic data has already corrected substantiality. Housing is in deep freeze, manufacturing is in contraction, earnings revisions have been ongoing, and the technology sector is seeing a slowdown too.¹ Much like investors should buy stocks when price-to-earnings (P/Es) are cheap vs. expensive, investors should think about adding risk when economic data is depressed vs. exuberant. For example, based on data going back to 1962, forward 6-month returns on the S&P 500 averaged 2.3% when the ISM Manufacturing PMI gauge was above 55 and averaged 6.1% when it dipped below 50.² Generally, a reading above 50 indicates that the economy is expanding while a reading below 50 indicates that it is generally declining.³

2. Inflation indicators have shown signs that inflation is set to moderate. For example, in the recent ISM manufacturing survey, the reading for the prices paid component – based on the percent of respondents indicating they paid more for inputs – continued to move lower and is now almost on par with levels seen in 2020 and 2016.⁴ This is welcoming news as the prices paid component leads overall inflation by roughly three months.⁵ Goods inflation, in particular, is set to continue to decline, fueled by the recent slump in oil prices.⁶ At the same time, North America fertilizer prices, which tend to lead year-over-year U.S. food inflation by a couple of quarters, are now down 40% year-over-year and should translate to slowing food inflation over the coming months.⁷ That said, the goods component of CPI is now running at 1.9% year-over-year compared with its June 2022 peak of ~16%.⁸ On the other end, service inflation, while still elevated at 7.5% year-over-year, has begun to show signs of rolling over as month-over-month increases have slowed from 0.8% in mid-2022 to 0.5% as of December 2022.⁹

The key to slowing service inflation is of course, the labor market. The BLS job opening survey and the ADP national employment report both came in higher than forecasted for the month of December.¹⁰ That said, the Fed would likely like to see more of a weakening in labor market before stopping rate hikes; however, the silver lining for markets right now is that the economy seems to be absorbing higher rates through slower activity, but not higher unemployment, preventing a deep recession. And yes, we will continue to see job cuts pile up as demand slows, but given the near record job openings (even if they come down) and lower labor force participation rate than pre-pandemic, this may result into a small rise in the unemployment rate and a rebalance across industries (for example, a correction of tech excess) and softer wages. Indeed, in the latest payrolls report there were larger than expected job gains, but average hourly earnings growth slowed more than consensus expectation.¹¹ Average hourly earnings growth now sits at 4.6% year-over-year compared with 5.6% year-over-year back in March of 2022.¹² Perhaps a soft landing after all.

3. Rising job cuts are what’s needed to reverse margin pressure. The bulk of the job cuts so far have been in the tech sector, accounting for 51% of the cumulative job cuts in the fourth quarter of 2022.¹³ Looking at the margins across sectors this should not be a surprise; tech boasts the highest profit margin across all 11 S&P 500 sectors. But that has been coming under pressure more so than the other sectors (aside from financials), declining from roughly 23.5% in the first quarter of 2022 to 21% most recently.¹⁴ This is not the first time we’ve seen a cyclical decline in tech margins, as it occurred in 2019 and 2015 before that. However, margins tended to improve as cost cutting measures were taken. Since May 2022 the tech sector has announced roughly 97,000 layoffs, reduced buyback authorizations, and slashed capex.¹⁵ These are exactly the corrective measures that the markets want to see tech companies (and others facing margin compression) take to pave the way for eventual margin and earnings growth improvement. And this is also exactly what the Fed wants to see as the committee pursues a less tight labor market.

4. Valuations have reset across sectors and across asset classes. Valuations moved materially lower over the last year, with bond valuations resetting the most on the back of rates rising from 0% to 4.5% through 2022.¹⁶ Equities have also reset lower and at current, do not appear as expensive as they were before.¹⁷ Within equities, the pockets that needed to correct have now done so. For example, SaaS software has contracted from 20x enterprise value (EV)/ forward revenues in November 2020, to ~5.5x today.¹⁸ Semiconductors P/E multiple declined from 23.5x in February 2021 to 17.8x today.¹⁹ And publicly traded REITs now trade at a 26.1% discount to net asset value (NAV).²⁰ In private markets we’ve seen venture capital valuation correct, private credit returns decline, and CRE price also started to correct.²¹

The price action we saw in the first two weeks of the year suggests that lower treasury yields could help cyclicals and rate sensitive sectors outperform. For example, semis, consumer discretionary and rate-sensitive sectors like REITs led the market on the days when yields were lower across the board. Indeed, our view is that long-term UST yields and their volatility has likely peaked, even if the Fed funds rate hasn’t yet. That is because slowdown in growth/recession and slowing inflation should pressure long-term yields down. As that happens, we suspect there is more of this sector outperformance to come.

The luxury of being both defensive for 1H ‘23 and opportunistic for 2H ‘23

2023 should be the year when consumers and investors get some reprieve from inflation and look for opportunities – across the risk reward spectrum. We do not expect a swift rebound in asset prices, as the tug-of-war between peaking inflation and the Fed that keeps reminding us that they are not done raising rates yet will likely continue for several more months. But, looking 6 months out, if consensus inflation expectations are right, the Fed should have “substantially more evidence of progress to be confident that inflation was on a sustained downward path” and this relief should help support the markets.²²

For investors this means that 1H ‘23 can present a significant opportunity to take advantage of the reset in valuations. And the good news is that investors can be both defensive for 1H ’23 and opportunistic for 2H ’23 and beyond. Defensive by holding cash, cash equivalents, and high-quality fixed income, all of which now pay respectable yields, and opportunistic by gradually deploying cash into opportunities like semis, public REITs, and investment grade fixed income, which have seen a large valuation correction. In private markets, our top ideas include committing to distressed private credit, buyout private equity, and opportunistic real estate.

For more insight on our top conviction ideas in the public and private markets, view our 2023 Market Outlook – The Time to Commit: Opportunities in the Public and Private Markets and Private Markets & Hedge Fund Strategy Ratings – Q4 2022.