Branstad

Everyone, thank you for joining us today for Thriving Asset Management's Capital Markets Perspective. I'm Jeff Branstad, a portfolio manager here. And this is Steve Lowe, chief investment strategist. Steve let's talk equity markets. The equities have started the year pretty well, actually. S&P has been up about 7.5% for the first quarter. What's been driving that?

Lowe

Yeah, it's a combination of several factors. One thing is the market entered in position short overall. So now is just simply short coverage, but also expectation of a Fed pause and a soft landing. You know, earnings are down, but they're holding up okay so far versus lowered expectations. You know, the economy's solid, but there are still numerous signs that the economy is weakening. But really, if you look at the market, it's the large cap tech names have driven it in, particularly the S&P. So, if you look at an equal weighted index, small caps, mid-caps, the Dow, they’re all in the low single digits for returns on the year.

Branstad

How is how is Thrivent Asset Management positioned?

Lowe

We've been underweight our long term strategy, which is to be overweight equities because equities outperform in the long run. So that leaves us roughly neutral overall equities versus fixed income, and we have a bias to kind of take off the risk is as the year proceeds, as we think the economy will slow and we're looking for opportunities to do so. But we want to be cautious about being, you know, too conservative in the near term.

Branstad

Okay, so you mentioned the rest of the year. So how do you kind of see the rest of the year playing out?

Lowe

Yeah. So, we expect the Fed to pause relatively soon if you look at how markets react to that. Equity markets rally typically after a pause and some of that's probably priced in because, you know, the market knows that. But as we get deeper into the year, we see rising risks to markets, you know, particularly a recession because of the impact of rates on the economy.

We expect earnings estimates to come down, given margin compression, you know, and a slowdown in global growth. So, our base case is that we retest the October 2022 lows, which are down 25% or get close to that most likely, you know, later in the second half of 2023. If you look at that low point, down 25%, that's about not quite to the recession averages. So, you know, markets were priced, first of all, they certainly haven't priced in a recession at this point.

Branstad

So, when might that begin to turn itself around?

Lowe

Yeah, I think later this year and possibly into 2024, you could see markets sustainably rally as they look ahead. You know, and when that happens, you know, earnings are very important. So, when there are signs that earnings are bottoming, we will see turn up. Typically, you see the equity market rally a little bit ahead of the bottom in earnings when there are signs the economy is bottoming, particularly if you look at some surveys in manufacturing, like the ISM survey, that typically happens about halfway through a recession.

And that's about when equities rally the equities rally before the recession ends, which makes sense because they're forward-looking. And then, you know, typically, if you look at where the Fed is equities rally, when the Fed is well along the way to cutting, because the reason they're cutting is, you know, they're worried about the economy. But toward the latter part of the cutting cycle, equities typically start rallying.

Branstad

Equities are always trying to stay one step ahead of what's actually going on.

Lowe

Exactly.

Branstad

You mentioned earnings earlier. What's your outlook there?

Lowe

Earnings are starting to look a little high right now so far, but they're going to be the key. If you look at consensus calls for a year over year growth to bottom in the second quarter of this year and then start turning up and actually be pretty positive by the fourth quarter and for the full year of 2023 estimates have earnings about flat.

That looks a little rosy. You know, and the reason what we're most concerned about is margin compression. So, the issue is that, you know, inflation and all the stimulus driven high has fueled higher revenue, higher sales, and particularly inflation. And now that's reversing. You have your revenues come down. But during the pandemic and, you know, it's easy to get sales growth companies rates because they hire people and costs always slowdown and at a slower pace, you get negative operating leverage.

So, we think that that'll happen. If you look at estimates, 2023 estimates have fallen about 10 to 20%, and that's from the estimate. We think there's more downside because you look at the median decline in earnings, typically in a recession and this is actual earnings estimates, it's about -13%. So, resetting estimates is really the key. One of the keys for getting the market to move forward.

Branstad

Yeah. Okay. Let's break down some of the equity asset classes. Let's start with market cap. What are your thoughts there? Large versus small?

Lowe

Yes, small cap valuations look cheap. They've looked cheap for a while. They're cheap historically to themselves or they're inexpensive compared to large caps. But valuations are not really a good timing tool. Is that necessarily a catalyst to outperformance? Markets can stay inexpensive for a long time. The risk to small caps is that they tend to be cyclical, and they also have a higher exposure to financials too, which the market is concerned about now.

So, we expect them to struggle somewhat in a slowing economy and particularly in a recession. And, you know, we've talked about this before. The best time to buy small caps is when you're near a market bottom, which means like sentiment is very poor. You know, fear is high and particular credit spreads are good for things like high yield, credit spreads are very high and that condition in particular, credit spreads are not at a level that small caps will typically rally, that they're actually really at their long-term median and they look expensive to us. So, what you want to do is try to buy them ahead of a cyclical upturn.

Branstad

So eventually there will come a time for us to lean into small caps, but we're not quite there yet.

Lowe

Probably later, you know, towards the end of this year.

Branstad

Okay. So how about growth and value.

Lowe

Yeah, growth trailed pretty significantly in 2022 by a wide margin to value its outperforming this year. And that's partly a function of lower rates growth stocks are very rate sensitive and also the pivot toward the perceived safety of growth companies because growth stocks should get a tailwind really from the scarcity of growth in a slowing economy. And, you know, we think the area to focus on and what's done well in particular are quality companies, these are companies that have very strong free cash flows and also strong balance sheets. So, in other words, what you want to do is be in companies that can weather a downturn or slowdown pretty well.

Branstad

All right. How about outside of the U.S., the international equity markets?

Lowe

Yeah, global equity has performed about in line with the U.S. global equities, excluding the U.S. Emerging markets have lagged while Europe has done very, very well. So, looking at the developed markets, first, you on a positive note on valuation. Europe and Japan look pretty attractive versus the U.S., which tends to trade at a premium or as you mentioned, valuation is a poor predictor of future returns, at least in the short term.

In the long run, that drives a little bit over the next year or two. Typically, valuation does not drive markets. You know, earnings momentum has looked pretty good in Europe and international versus the U.S. and returns have also been helped by it by a weaker dollar, which maybe has some further weakening expected in the dollar. But it's a trend that's going to probably slow down later this year.

So, if you look at headwinds then, the main issue is with Europe is core inflation is, you know, very persistent there. And that's going to keep the ECB, you know, very, very aggressive. So, we're concerned about higher rates and the impact on the economy there. Last year for Europe, everything worked out pretty well. You know, it outperformed expectations by a wide margin.

Part of that was energy related. And they did a good job of building up gas storage. And gas prices actually fell pretty significantly by the end of the year. The other issue with Europe, though, is that the ECB is also doing quantitative tightening and selling assets. So that combined with higher rates should pressure the EU liquidity in the economy over time.

That happens in the way in impact and Europe tends to be much more cyclical. So as the global economy slows, that's going to hit Europe too. And there are key differences in sectors. The U.S. is much more tech heavy. And, you know, there we think there's still some exciting new technologies, such as the impact of artificial intelligence that, you know, over the long run world will drive, help drive tech here.

Branstad

So, if you're underweight, developed international, what are your views on emerging markets?

Lowe

Yeah, we're more positive there again, you know valuations.

Branstad

Yeah, valuations.

Lowe

You know look relatively attractive versus the U.S. you know, the key issue there for emerging markets and China is a large part of it, is that China's reopening, you know, the manufacturing has slowed somewhat, but the service economy is starting that. And I think in particular, the U.S. economy will do well and they're starting to add more stimulus to the economy and credit. You know, they recently had GDP numbers that outperformed. But again, if the global economy slows, EM is going to tend to be more sectoral and more tied to global trade. So that leaves us kind of overall modestly underweight international. But we favor EM within international.

Branstad

Okay. So, we're likely to see some downward pressure on markets in this in the short term. You were favoring large cap right now, quality companies and U.S. companies.

Lowe

Yes. And with international.

Branstad

Emerging market emerging markets, yes. Thank you all for joining us to get our perspective on the capital markets. And thank you, Steve, for the great information today. Goodbye.