First Quarter Developments
As the first quarter ends, equity markets have registered respectable returns, especially given the myriad of issues present. Whether they be bank insolvencies, inverted yield curves, prospective Federal Reserve (Fed) actions, or a parade of geopolitical issues, capital markets remained buoyant.
These positive results despite the uncertainties could stem from the reversal of short-selling tendencies of investors coupled with renewed interest in securities heavily impacted by year-end tax loss harvesting activities. Additionally, perceptions related to stronger-than-expected economic results, combined with the prospect that the Fed might soon conclude its rate hiking operations have generated optimism.
This market positivity, though, presents a tension between economic fundamentals and valuation. Stock prices should reflect the state of corporate profitability relating to interest rates and inflation. With the Standard and Poor’s (S&P) 500 earnings-per-share (EPS) estimates for the first quarter of 2023 declining, continued gains become more challenging.
Consistent with rising stocks are declining US Treasury yields, which counter the purpose of the Fed’s fed funds rate hikes. Continued market gains in the face of still uncomfortably high inflation increase the likelihood of more aggressive monetary policies over the next few months, despite fragility in the banking system.
We are presented with a scenario where the 10-year Treasury note sits at 3.48% and the core consumer price inflation rate is 5.5%. Both metrics register above their ten-year average in an environment where the consensus expectation is a prospective recession accompanied by declining corporate profits.