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OUR VIEW

A look ahead: Second quarter 2023 outlook

10/12/2021

04/18/2023

10/12/2021

A look ahead: Second quarter 2023 outlook

Fixed income market

Treasury yields are decidedly lower than the current rate of inflation. It is important to the Federal Reserve (Fed) that it remain resolute in fighting inflation and that investors are confident in this conviction.

It seems unlikely that the Fed would reverse policy and begin cutting rates later this year. However, that prospect may change if we see further negative surprises from the banking industry or a rapid  slowdown in the economy.

Current yields of 8–12% in the higher-risk areas of the fixed-income market rival or exceed expected equity market returns. Investing in this area should be viewed as an alternative not to higher-quality fixed-income investments, but closer to equity investments.

Equity market

Mega-cap technology stocks have recovered strongly as investors migrate back to high-quality, low-capital-intensity, and less cyclical stocks.

From a longer-term standpoint, smaller-capitalization and value equities remain historically cheaper relative to larger-capitalization growth equities. However, these sectors of the equity market perform better when the economy transitions from contraction to expansion.

International and emerging-market equities had been performing well until the surprising banking turbulence. Like small-cap and value U.S. stocks, international stocks will need to see clearer economic skies to truly regain their performance footing.

What is needed to get more aggressive across fixed income credit and equities? 

More attractive overall valuations along with clear evidence that inflation is retreating, an easing of Fed monetary policy, stability in the banking and financial system, and a stable economy poised for expansion.

Related content:

Capital Markets Perspective (PDF)

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Asset allocation views: Current outlook

 

Equity vs. Fixed Income

The negativity of 2022’s volatility trend has eased this year as investors have not only demonstrated resistance to material deterioration but also a degree of positive energy. This is especially true in the large growth space. Broadly speaking, the patterns and trends within equities are favorable long term. However, macroeconomic headwinds are building, and the earnings outlook remains vulnerable.

Diminished inflationary pressures, improving consumer sentiment, and the strength/composition of Q1 equity performance provide a basis for cautious optimism.

Equities

Equities

 

U.S. vs. Int’l.

Despite recent relative strength versus domestic, we continue to favor domestic over international in the intermediate-to-long term. Support to our positioning includes peak globalization and the increase in reshoring by U.S. companies, a higher degree of innovation domestically, greater demographic issues internationally, structural impediments to growth in Europe, and a more favorable climate for businesses (e.g. regulation) domestically. Over the past three to six months, the avoidance of recession in Europe helped the MSCI EAFE index1 outperform the S&P 500 index.2 We believe this tailwind for European equities has largely run its course.

The dollar has been depreciating since peaking in September of 2022. The continuation of dollar depreciation would benefit international equities, particularly in emerging markets.

 

Market Cap

We are overweight both small and mid (smid) caps, with a bigger overweight to mid caps. When they outperform large caps significantly, small and mid tend to do so simultaneously.

Small-cap valuations are quite low both on an absolute basis and relative to large caps. Additionally, sentiment is generally low, which often favors small caps. Small caps will likely need to see economic prospects stop deteriorating and a risk appetite return to equity markets before a more sustained period of outperformance can occur versus large caps.

Despite the relative valuation, small caps are at risk of underperformance should more than a modest recession occur.

Fixed-income

 

Duration

We believe that, as inflation is significantly higher than 2% and employment and the economy remain strong, the Fed will remain in tightening mode, with short-term rates rising with Fed Funds.

Longer-term rates, however, likely have peaked absent an unexpected inflation surge. We expect long-term rates to be steady-to-down, reflecting concerns over the economy and falling inflation.

 

Credit Quality3

In 2022, credit returns were sharply negative due to higher interest rates and wider credit spreads. In 2023, we expect credit markets to be increasingly driven by concerns over a slowing economy and the possibility of a recession due to tightening financial conditions.

If the economy significantly slows, credit spreads have meaningful downside with defaults likely rising in lower-quality credit.

We intend to tactically lower credit risk should the probability of a recession increase further than our expectations. If spreads increase to around average recessionary levels, we intend to start adding back credit risk.

1 The MSCI EAFE Index tracks the performance of developed-economy stocks in Europe, Australasia and the Far East.

2 The S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.

3 Credit Quality ratings are determined by credit rating agencies Moody’s Investor Services, Inc. or Standard & Poor’s Financial Services, LLC.

The Senior Investment Team is discussing the asset classes, sectors and portfolios they oversee at a macroeconomic level. The views expressed are as of the date given unless otherwise noted and may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or recommendations of any particular security, strategy or product.

Past performance is not necessarily indicative of future results.

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