Branstad: Thank you everyone for joining us today. I'm Jeff Branstad with Thrivent Asset Management, and this is Steve Lowe, our chief investment strategist.
Steve, let's talk a little bit about the equity markets; they suffered badly in 2022. So, how are you approaching 2023?
Lowe: You're right. It was a bad year for equities. They finished down pretty significantly. Valuations, on the positive side, are much improved. We're entering this year somewhat cautious. The Fed is raising rates, inflation is still high, and we're expecting continued volatility. We think a recession is more likely than not this year, toward the end of the year, as the lagged impact of higher rates hits the economy.
Our base case is that we retest or set new lows in the equity market probably around the end of the first half [of the year] or beginning of the second half, somewhere in that time frame, maybe later if inflation is a little bit sticky. But we’re reluctant to be overly cautious because we think there will be opportunities to add risk this year.
Branstad: When do you think those opportunities might start arising? Right away, or a little bit longer down the line?
Lowe: I think a little bit longer down the line. I think that, as we increasingly get into the year, markets will look forward to a recovery and most likely end the year higher. So, that's probably toward the end of the first half, beginning of the second half, depending on how inflation and the Fed play out. We are watching closely for signs that inflation is sustainably slowing and that the Fed is easing.
While we will be tactical this year – as we have been – we're more guided by a longer-term, strategic view for this year. If you look at when bear markets are reached – which they were last year – on a longer-term horizon, markets are more likely up then down. The probability of a loss over a year from when a bear market is reached is relatively low, somewhere around 20% or so. We want to be positioned to participate in that rally partly because, historically, turning points can happen very quickly.
Branstad: Yeah. You never want to miss out on that first wave of the of the recovery. So, how about equity valuations? How are they – how are those looking?
Lowe: Yeah, they’re looking better. If you look at 2022, most of the decline in stock markets was purely through valuation. The P/E multiple – price-to-earnings multiple – declined. That’s called “derating.” That drove markets more than falling earnings because earnings tend to lag the market to some extent. The lower valuation was driven by expectations of a slower economy – in particular, by higher rates.
You saw rate-sensitive areas like growth stocks – tech companies, for example – really get hit hard by higher rates. So, valuations entered 2022 extremely high, but they've fallen and they're moderately attractive now. I would say, if you look at the S&P 500®, it was about 25x earnings [at the start of 2022]. Now it's around 17x, which is close to a 30-year median. NASDAQ, too, entered  extremely rich, 35x earnings. It's [now] closer to 21x, which is also close to the 30-year median.
Branstad: How about the earnings side of that equation? How are earnings going to be impacting the market?
Lowe: Yeah, that’s a good question. Earnings ultimately drive markets, particularly over the long run. Earnings have held up pretty well. Estimates have been falling more quickly recently. You're seeing companies cutting their estimates and you're seeing analysts cut their estimates of what companies will earn.
But 2023 earnings have fallen a bit, but it still looks high. The consensus estimate is that S&P earnings will be up 5% this year. That's low for a slow economy where a recession earnings usually decline by about 15%. It's just too rosy given inflation, high rates and most likely what will be a slowing economy. We expect margins to come under pressure, particularly as prices start falling. I think one key to markets moving forward is for earnings to be reset lower and clearing the way, flushing out earnings estimates; it clears the way for markets to move forward and rally eventually.
Branstad: Can you talk a little bit about how Thrivent is positioned in this type of market environment?
Lowe: Yeah, we are – as we have been – modestly overweight equities versus fixed income. If you look within equities, we've been overweight domestic. And that's really focused on what we would call smid cap, or small and mid cap, and it’s much more so on mid caps. We like mid caps: we have very good managers for one thing; the other is they tend to be more profitable – a lot of small caps are not. And [mid caps are] tomorrow’s large caps eventually, and acquisition targets potentially. And they performed pretty well in 2022.
Small-cap valuations are cheap – they’re cheap to their own history. They're cheap relative to large caps. So, that gives them this valuation cushion which allows them to withstand some slowing in the economy. So, we've added some to small caps, but we're kind of holding back. Small caps typically rally in a cyclical turn and when fear lessens. And we think that's more of a later 2023 event.
Branstad: What about style – growth versus value?
Lowe: Yeah. Value absolutely crushed growth last year – 20% margin. That's really a function of rates. Higher rates impacted growth stocks, and higher inflation – value tends to do better in a higher inflation environment. And then, the composition. Energy is value; materials and those benefited from good commodity markets.
I think growth has corrected a lot in valuation. So, it's more attractive. But value historically has outperformed in high inflation and particularly even after the last of the Fed rate cuts. So, there's probably a little more runway there. But ultimately value is going to be impacted in segments of it by slowing the economy. Growth stocks should get a tailwind from lower rates. That was one of the things that drove negative returns in 2022. And in a slowing economy and a recession, there’s a scarcity of growth – tends to favor secular growth companies, quality secular growth companies.
Branstad: Let’s shift our focus overseas. Could you talk a little bit about our viewpoint on international stocks?
Lowe: Yeah, we’ve overweight domestic very moderately, but we've been starting to lessen that right now. Our moderate underweight to international has been focused more on developed and less so on emerging markets.
So, if you look at the developed area, Europe is key. It's the third largest economy right now by GDP after the U.S. and China. A recession is still highly likely there. They've been hit by high inflation. A lot of that's driven by commodity prices. You saw gasoline, oil prices and natural gas prices shoot up after the Ukraine war and with Russian sanctions. The ECB is hiking into a slowing economy, and very aggressively. They're very hawkish in their statements, and they’re determined to fight inflation, which is much higher in Europe than it is here. And then earnings estimates in Europe just look too high. They really haven't corrected. As for other key developed markets: Japan has been mired in a slow-growth environment. We don't see that changing anytime soon. And then the U.K. is likely facing a multiple-year recession.
Branstad: So, you mentioned China, one of the largest economies in the world. They're a big driver in [emerging markets, or EM]. Can you talk EM a bit?
Lowe: Yeah, emerging markets were hurt last year at times by a strong dollar. That can hurt companies with a lot of dollar-denominated debt. It affects their own currencies, and it causes inflation to go high because a lot of things are priced in dollars, particularly commodities. China, which is the largest emerging market by far, suffered from slowing growth to a large extent caused by Covid shutdowns, but also a slowing global economy. And then they have a distressed property sector.
If you look at the international markets in general, both developed and emerging markets, a lot of what were headwinds are flipping to tailwinds. Valuations are attractive, so that's a very good positive. We expect lower rates and that should help weaken the dollar, which in turn will help international, particularly emerging markets.
China is ending Zero Covid. They've already done that, and you can see a path to the economy reopening this spring and picking up. I think it's going to be a volatile path, but we expect China to resume growth or stronger growth toward the spring.
Inflation should moderate in Europe eventually. Both EM – emerging markets – and Europe should benefit from a rebound of global trade later in the year; EM in particular tends to lead a global economy as far as markets are concerned. And then a weaker dollar, which is what we expect, improves international returns if you're translating euros or yen back into dollars; a weaker dollar helps boost returns.
Branstad: Yeah. So, lots of challenges still out there, but that also leads to opportunities as those kinds of headwinds flip to tailwinds. That's really great info. Again, thank you, everyone, for joining us. Thank you, Steve. And we'll see you again the next time.
Lowe: Thank you.