Market Uncertainties: Buy Weakness, Sell Strength

For the remainder of 2023, equity markets will undergo a wide range of outcomes, and flexibility will be crucial in navigating this volatility. In today's world, it's more important than ever to change your mind when the facts change.

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In light of the current U.S. banking system stress, what are the implications for the market outlook? Are we heading for a recession in the United States? Can inflation reach the 2% target set by the Federal Reserve? In this year's S&P 500, what level of earnings can be expected?

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The present volatility needs to be viewed in the context of long-term opportunities and challenges. Three U.S. banks have failed recently, including Silicon Valley Bank, the nation's 16th-largest bank by assets, and Credit Suisse has been forced to sell after 167 years. As a result of Credit Suisse being acquired by UBS in a deal worth $3.2 billion, the global banking system was relieved of significant stress. Yet, despite Fed and Swiss banking authorities' swift responses to restore confidence, fears of more systemic issues continue to roil markets. Investors should focus on what measures the Federal Reserve will take next if these bank failures remain contained.

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Banks have been argued to be stressed by the Fed's aggressive monetary tightening. It is far less likely today that we will see continued monetary tightening. Markets have begun discounting cuts before year's end, and "Fed pivot" narratives are returning. It is not the Fed's intention to magnify stress in banks, but if interest rates are cut too quickly, inflation may reaccelerate, which could lead to a reactivation of the problem. Expectations of a rate cut by the Fed are premature. The Fed will remain vigilant when it comes to inflation. It is more likely than not that the Fed will cut rates this year. 

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Investors have been concerned about the possibility of a U.S. recession. Markets are dampened by the topic.

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World Economic Forum estimates that a recession typically occurs within 12 months after the yield curve inverts, as it did in October. There has been a near-perfect track record of U.S. bond market predictions of recessions, but is this recession any different? 

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It has been a year since the fall that equity-market sentiment improved. Investors are encouraged by strong economic indicators such as employment, wages, and spending, which suggest a recession may not occur. Even though this is possible, the Fed is concerned about inflation due to these same consumer factors. Consequently, there is a high risk of recession. 

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There is no doubt that inflation has peaked, but how fast will it fall, and to what level will it decline? It is an important and difficult variable to forecast. It was the Fed that realized inflation was a persistent problem and needed to be addressed. Ultimately, it responded aggressively, but late, resulting in more drastic measures.

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Despite its unrealistic inflation target of 2%, the Fed maintains its inflation target. Despite labor supply challenges, wage inflation is likely to persist in the near future as service demand remains strong. As a result, markets may have to become accustomed to inflation closer to 3%, or even 4%, instead of the sub-2% we've been enjoying for so long.

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It is also possible that China will reopen its economy. Since China is one of the most important global suppliers, easing the country's controversial zero-input-output policy and supporting the property sector is positive for the Chinese economy and the global economy. It is possible that Chinese demand will exacerbate inflation in the long run, even though the reopening of China may help stave off a U.S. recession. Inflation will likely stay above the Fed's target of 2% regardless of how it unfolds, at a minimum.

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Investors are also concerned about earnings since stock prices typically follow earnings. The S&P 500's earnings expectations have fallen over the past few quarters. More recently, the market has predicted earnings of roughly $225 per share in 2023, down from $250 last summer. The market has had a difficult time navigating this headwind.

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It is likely that earnings will continue to decline this year, which will be a source of concern for investors. Several industries, including banks and consumer durables, are experiencing inflationary pressure, which could squeeze margins. In spite of strong spending trends, there is a real possibility of a meaningful slowdown due to the health of the consumer. Earnings power is likely to suffer further from the Fed's aggressive tightening because it has not yet been fully metabolized. The downside of earnings from current levels should be moderate, but there is earnings risk. However, equity markets face a challenge because there is no upside.

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So what do we do? Simply put, buy weakness and sell strength. Markets are no longer one-decision affairs. When easy money was available, investors bought every dip, but now they need an active approach. Investing will be successful if you are able to find companies that have better fundamentals than the market appreciates, not if you are exposed to factors.

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While the market remains uncertain, astute investors may still find growth opportunities, particularly in idiosyncratic sectors. Healthcare's durable spending and innovative devices, services, and biopharma make it a particularly attractive sector. Demand and supply could be tightening for energy. A near-decade low in stock valuations for small-cap U.S. companies makes them an attractive investment.

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As inflation, labor, and earnings pressures persist, volatility is expected to reign in the near term. As the year progresses, investors need to keep an eye on the data. Stay active and focus on the company's fundamentals. Get ready for the upside if the Fed succeeds in taming inflation, and buckle up if it fails. It doesn't matter how you look at it, the winds are always changing.