The S&P 500 has risen more than 7% since the Silicon Valley Bank/Signature Bank collapses in early March. Yet, the bulk of the performance has come from just a handful of businesses. In the past month, Apple and Microsoft have accounted for roughly 25% of the index return. This contrasts starkly with much of 2022, where earnings multiples on mega-cap growth stocks — those with more than $200 billion in market value — were compressed by a steady climb in interest rates.
With recession odds rising due to tighter financial conditions, interest rates have begun to reverse course, and pressure on earnings multiples has eased. In many ways, it has been a "bad news is good news" environment for growth stocks. Still, the market continues to wrestle with the Fed's unwavering commitment to return inflation to 2%. Despite clear evidence that inflation is slowing, Fed members appear to be gearing up for another 25 basis-point hike at their next meeting on May 3. The lack of market breadth reflects an anxiety that the Fed will go too far in raising interest rates.
March's consumer and producer price reports continued to showcase inflation on a lower trajectory. Core CPI is down to 5.6% on a year-over-year basis, and Core PPI is down to 3.4% on a YoY basis. The dramatic easing in goods inflation continues to be offset by rising rents. However, survey measures of rents lag actual market rents. More timely measures of market data show that shelter costs should begin to ease in the months ahead. Still, core service inflation remains higher than the Fed would like at 6.1% YoY. With a ratio of 1.7 job openings for every unemployed person, wage pressures are still influencing service sector pricing. In the Fed's view, labor demand still needs to be balanced with labor supply. They are unlikely to deviate too far from the tightening path until they see some real softening in the labor market. The Fed's forecasts show the unemployment rate rising to 4.3% by the end of the year.
We have yet to see evidence of meaningful deterioration in the labor market. However, leading indicators point toward softer labor conditions in the months ahead. With money market rates far outpacing the average deposit rate, deposits are being drained from the system and parked in the Fed's reverse repo facilities, pulling more money out of the economy. Banks, particularly regional banks, are having to raise deposit rates at the expense of profitability. Lending standards are tightening as a result. As this works through the system, we expect job losses will ultimately pick up as has historically been the case. Monetary policy acts with a lag and we may just now be seeing the impact of 475 bps of hikes within a span of just 12 months. Conditions will only tighten further if the Fed continues its quest to 2%.
With the economic backdrop uncertain at best, we continue to focus on owning the highest quality companies. We are looking for companies that have sustainable competitive advantages, thoughtful use of debt, resilient cash flows, outstanding management teams, necessary goods and services, and good values. Timing out a recession is difficult, but this focus should help filter out the noise.
Preston May, CBE®
This report was prepared by Donaldson Capital Management, LLC, a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information in these materials are from sources Donaldson Capital Management, LLC deems reliable, however we do not attest to their accuracy.
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S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.