A lot has changed in the past few weeks, both in terms of expectations for interest rates and lost confidence in the health of the banking system as a result of the sharp rise in interest rates that has led to some things “breaking,” as we wrote about here last week. Here we share some thoughts on who’s to blame for the ongoing banking crisis and reiterate how we are telling investors to adjust, or not adjust, their asset allocations in light of ongoing market volatility.  

Markets On Alert

It’s difficult to grasp that just a few weeks ago, the fed funds futures market had priced the terminal rate at nearly 6%. The market’s hawkish outlook was predicated on the Federal Reserve (Fed) raising rates amid a still solid economy underpinned by a tight labor market and consumer spending, but with inflation still above the 2% level that reflects price stability.

Now, with continued pressure on both domestic and global banks, markets are expecting the Fed will be forced to cut rates towards the end of this year as loan growth slows and businesses, particularly small businesses, and consumers find it more difficult to secure loans. As a result, the broader economy is expected to be negatively affected.

The rapid collapse of Silicon Valley Bank (SVB), followed by continued pressure on regional banks, along with headlines surrounding the struggle to shore up confidence in First Republic Bank (FRC), has the market on alert for other potentially vulnerable banks. The banking stress of the past couple of weeks has put some heavy pressure on the bank-heavy small cap Russell 2000 Index (Figure 1).

The swift crash of Signature Bank, the third largest bank failure in U.S. history, following the demise of SVB, which held $160 billion in deposits, along with Silvergate Bank, has investors and depositors questioning if the banking system is as “sound and resilient with strong capital and liquidity” as suggested recently by both Fed Chair Jerome Powell and Secretary of the Treasury Janet Yellen.

To be sure, the Fed’s emergency bank lending facility, the Bank Term Funding Program, which was quickly put in place to help strengthen the banks, also served to restore confidence as banks grapple with depositors who are seeking higher rates elsewhere, and who are also increasingly concerned about the viability of the banks themselves.

Finger pointing: Who’s to blame?

No sooner had news regarding the run on SVB hit the media, generalized fear and panic spread quickly. Depositors mounted a modern-day run on the bank using their smart phones, and over the course of 36 hours, the bank was forced to sell $21 billion of long duration bonds at a loss of $1.8 billion.

The blame was quickly focused on venture capitalists who sent out immediate warnings to their start-up companies to withdraw their funds at once. SVB’s large client base was broadly made up of fledgling technology companies backed by venture capital. It didn’t take long for depositors to exit.

A widely followed newsletter that covers the venture capital world, “The Diff,” has also been considered the spark that led to the mass exodus of deposits, when in late February the report indicated that SVB’s debt-to-asset ratio was 185 to 1, implying that the bank was virtually insolvent. The underlying culture of the tech world has also come under scrutiny as to how rapidly conclusions were drawn and how instantaneously they were acted upon.

Mismanagement and regulatory failures

The deficit of a functioning risk management team has been the most enduring criticism of SVB, while criticism has similarly been leveled at the supervisory team at the San Francisco Fed, which is supposed to monitor the operations of the banks within its regulatory jurisdiction. The lack of communication from the bank’s senior leadership didn’t help matters.

Silvergate Bank, with $12 billion in deposits, is most closely associated with crypto activities, but suffered a swift run on its holdings around the same time as the SVB failure. Despite early warnings of fragility in the wider crypto world, and with risks climbing, there was apparently, according to media reports, little contact with supervisors from the San Francisco Fed.

At the Federal Open Market Committee (FOMC) meeting press conference on March 22, Powell addressed criticism that there wasn’t any supervision of operations at SVB. He stressed that there were red flags raised months ago by examiners from the San Francisco Fed, but he couldn’t say whether the warnings were escalated. “We’re doing the review of supervision and regulation,” Powell said, and “My only interest is that we identify what went wrong here.”

Senator Elizabeth Warren, the leading Democrat on the Senate Banking Committee, blamed Powell for the banking crisis in no uncertain terms, saying that he was an integral part of the process that weakened regulatory oversight of regional banks, “Fed Chair Powell’s actions contributed to these bank failures.”

Monetary and fiscal policy

Moving up the blame chain leads directly to the monetary and fiscal policies that flooded the banking system with government transfers to consumers and small businesses, coupled with interest rates that stayed near zero for too long, which allowed risk to intensify across the investing spectrum.

With the Fed’s insistence that the inflationary effect was “transitory” and primarily due to COVID-19-related supply chain challenges, the central bank was slow to begin raising interest rates. With financial conditions remaining loose, risk taking was elevated in venture capital, private equity, and real estate, especially commercial real estate. But as the Fed finally launched its aggressive rate hiking campaign, the dynamic changed.

The collapse of SVB, followed by the other banks that were victims of the immediate panic that ensued, is emblematic of the changing landscape. When all is said and done, the blame falls on all of the above for failing to recognize the risks associated with policies that allowed risk taking but then quickly turned off the spigots.

Asset Allocation Views

In the current environment of elevated volatility and concerns about banks, LPL Research believes tactical investors should still maintain multi-asset allocations at or near benchmark levels with an emphasis on diversification.

Within fixed income, LPL Research continues to like the preferred sector to take advantage of attractive valuations with less risk than equities.

Within equities, the technology sector looks better to us here, which, along with the Strategic and Tactical Asset Allocation Committee’s (STAAC) recent decision to downgrade healthcare to neutral, suggests limiting the size of any style tilts toward value. The Committee continues to take a wait and see approach on the banks while closely watching the latest developments. Finally, precious metals-related investments warrant consideration on the long side, in our view.

Quincy Krosby, PhD, Chief Global Strategist, LPL Financial

Jeffrey Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Last week did not play out how we anticipated. Coming into the week, it was all about Federal Reserve (Fed) Chair Jerome Powell’s congressional testimony and the February jobs report. Instead, we got a shockingly fast collapse of a financial institution with over $200 billion in assets, which turned the market’s focus toward the stability of the banking system and what systemic risks banks might be facing. This commentary is focused on our asset allocation views, but no doubt the Silicon Valley Bank saga will require more attention from investors in the days ahead.

Maintaining Recommended Equity Allocations Despite Latest Developments

A tough environment for asset allocators just got tougher with the events of the past few days. For the “no landing” crowd thinking strong consumer spending and low unemployment would keep this economy growing until the inflation fight is won, they now have to consider signs of stress in the banking system after the failure of SVB Financial (commonly known as Silicon Valley Bank). See the LPL Research blog for our latest thoughts on that situation.  

The stock market bulls also had to absorb hawkish testimony from Fed Chair Powell that led the bond market to increase the chances of a 50 basis point rate hike on March 22 (though those expectations unwound following the SVB news). Add to that a troublesome last round of inflation data and the most inverted yield curve in four decades, based on 2- and 10-year Treasury bonds, and the bulls don’t have the firmest ground to stand on.

But this market has also made it tough for the bears to get it right. The cyclical, so-called “high beta” stocks have been outperforming—the late-week selloff in the banks notwithstanding. Double-digit gains from the October lows were accompanied by strong breadth—a sign of a healthy bull market with a broad range of stocks participating in the rally. Recent economic data has pointed to continued growth—giving rise to the “no landing” narrative. Earnings estimates have held up better than many expected. We’re in a very strong seasonal period for stocks, based on the four-year presidential cycle (year three has an average gain of 16.8%, higher 89% of the time since 1950). Fed pauses—likely coming fairly soon—have historically been followed by double-digit returns one year later, on average.

So the case for gains this year seems strong based on history, enough for the LPL Research Strategic and Tactical Asset Allocation Committee (STAAC) to continue to recommend an overweight equities position. However, the pressure on valuations from higher interest rates, which have made bonds attractive alternatives, led to the Committee’s recent decision to reduce the size of the overweight from 5 points to 3.

Not Enough Evidence to Switch Back to Growth

Growth stocks have come storming back in 2023 after significantly underperforming their value counterparts in 2022. The Russell 1000 Growth Index has returned 4.6% year to date, compared to the 2.3% decline for the value index. The question now is have growth stocks shown enough to reclaim leadership and sustain the outperformance.

Starting with the technical analysis picture, the improving relative strength has pushed the Russell 1000 Growth (RLG)/Russell 1000 Value (RLV) ratio chart back above its declining 200-day moving average. However, technically, the ratio chart has yet to recapture the lower end of its prior range and until that area of overhead resistance is cleared, we believe the sustainability of growth outperformance remains questionable (Figure 1).

From a fundamental perspective, the near-term outlook for the value style has gotten much tougher following the banking selloff last week. Financials are the biggest value sector, composing 20% of the Russell 1000 Value Index, compared with just 3% of the Growth Index.

But valuations strongly favor value over growth. Despite the strong 2022 for value in which the Russell 1000 Value Index outperformed the Growth Index by more than 20 percentage points, the Value Index still trades at a 38% discount to growth compared with the respective 10- and 20-year average discounts of 28% and 25%.

Other reasons the STAAC maintains a slight preference for value include the Committee’s favorable view of energy, which is the second biggest value sector, and value’s record of outperformance during rising interest rate and high inflation periods.

Small Cap Valuations Offer Some Cushion for Business Cycle Risks

Small caps would typically not be one that asset allocators would recommend when some of the most prescient leading economic indicators are sending strong recession signals. They tend to do better early in economic cycles once the economy emerges from recession. If the common—though not quite unanimous—view that recession may come in 2023 or early 2024 turns out to be right, then the sweet spot for small caps may be a year or more away.

But small caps have performed relatively well this year, despite the economic uncertainty. The S&P 600 small cap index has returned about 1.5% year to date, while the Russell 2000 Index is up 0.9%, after both lost more than 7.5% last week.

We would cite valuations as the primary reason small caps have held up amid concerns about stress in the banking system (which we do not see as systemic). The small cap indexes carry more financials than large caps, (about 8% more based on the Russell 2000 and S&P 500 indexes) and generally companies’ balance sheets are not as strong.

Small caps look cheap enough to us here to favor despite these risks. As shown in Figure 2, the S&P 600 Small Cap Index trades at a 13.6 price-to-earnings ratio (P/E), well below its 10-year average at 17.2. For comparison, the S&P 500 Index trades at a 17.2 P/E, right in line with its 10-year average.

The technical setup for large caps versus small caps, based on the ratio chart for the S&P indexes, remains in a downtrend and below its declining 200-day moving average, implying the trend still favors small cap outperformance ahead.

Developed International A Worthy Alternative to The United States

LPL Research’s outlook for developed international equities has improved in recent months. Based on the combination of improving technical analysis trends, attractive valuations, and resilient performance by European economies thanks to falling energy prices, the STAAC’s allocation to international has been increased to near that of U.S. equities. Specifically, the Committee recommends a neutral allocation to international and a 3-4% overweight to U.S. equities.

The earnings growth picture suggests a similar outlook for developed international and U.S. equities, as shown in Figure 3. These are just estimates, but consensus currently reflects 1.8% growth in earnings for the S&P 500 and MSCI EAFE indexes. The outlier is emerging markets (EM)—the MSCI EM Index is expected to see a 3.4% decline in earnings in 2023.

Not only is EM expected to see earnings fall this year, the momentum in those estimates is clearly negative (Figure 4). The U.S. earnings estimate trend is starting to inch higher, recent strength in international estimates has begun to roll over, and EM estimates have drifted lower over most of the past year. These earnings trends generally match our views on these three regions. Ongoing U.S.-China tensions and regulatory uncertainty add to our EM concerns.

From a technical perspective, international developed continues to outperform U.S. equity markets. The MSCI EAFE Index vs S&P 500 ratio chart has been climbing higher since October, with no signs of a trend change on the horizon. Emerging markets are beginning to look more constructive on a technical basis; however, there is insufficient technical evidence to make the call for a trend change at this time. Based on this backdrop, we prefer international developed markets over emerging markets. The STAAC’s next move is more likely to be upping developed international equities rather than emerging markets.

Conclusion

In conclusion, LPL Research maintains a slight preference for equities over fixed income, value over growth, small caps over large caps, and U.S. and developed international over emerging markets. The STAAC continues to watch for more clarity as to how long the inflation problem will persist, how far the Fed will have to go to tame it, and whether the U.S. economy can prove its skeptics wrong, muddle through, and avoid a recession. The failure of Silicon Valley Bank doesn’t make the road ahead for the economy any easier, but it may offer a silver lining for markets by slowing the Fed down.

Jeffrey Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Adam Turnquist, CMT, Chief Technical Strategist, LPL Financial

While concerns about the debt ceiling have been increasing, markets, businesses, and the economy are likely to see only minimal impact until we are days, or maybe a few weeks, from the “x date,” the date on which the federal government will no longer be able to meet all its obligations, likely in the summer or early fall. We continue to believe the chances that Congress will fail to raise the debt ceiling before the x date remain extremely low, but current political dynamics have likely increased the risk and there are some negative consequences to even an eleventh-hour agreement, as we saw in 2011.

Debt ceiling drama is once again increasing, but the build-up will be slow. The Department of the Treasury (Treasury) has been using “extraordinary measures” to cover debt payments since January 19, but that has not been an unusual course of action and does not impact the government’s ability to function smoothly. Markets, businesses, and the economy are likely to see only minimal impact from the debt ceiling debate until we are days, or maybe a few weeks, from the “x date,” the date on which the federal government will no longer be able to meet all its obligations. That date will likely be in the summer or early fall, depending on tax receipts and other factors.

We continue to believe the likelihood the debt ceiling won’t be raised in time remains extremely low. Nevertheless, uncertainty about whether it will be raised can have its cost. We believe those costs are currently near negligible and will build slowly. Risks will increase more quickly if we are several weeks away from the x date and still appear to be at a deep political impasse. The mere appearance of Democrats and Republicans playing politics near the deadline can weigh on markets and force businesses to start preparing for the very unlikely, but still possible, outcome of a government default. The current political dynamics, with a split Congress and a thin majority in both the House and Senate, have likely increased the overall risk and there are some negative consequences to even an eleventh-hour agreement, as we saw in 2011.

U.S. Debt Ceiling Questions Answered

1. What is the debt ceiling?

The debt ceiling is the limit on how much the federal government can borrow. Unlike every other democratic country (except Denmark), a limit on borrowing is set by statute in the U.S., which means Congress must raise the debt ceiling for additional borrowing to take place.

2. Why does the U.S. do it differently?

The debt ceiling was originally created to make borrowing easier by unifying a sprawling process for issuing debt to help fund U.S. participation in World War I. The process was further streamlined to help fund participation in World War II, creating the debt ceiling process that is in use today. According to the Constitution, Congress is responsible for authorizing debt issuance, but there are many potential mechanisms that could make the process smoother.

3. Why is it important to raise the debt ceiling?

The government uses a combination of revenue, mostly through taxes, and additional borrowing to pay its current bills—including Social Security, Medicare, and military salaries—as well as the interest and principal on outstanding debt. If the debt ceiling isn’t raised, the government will not meet all its current obligations and could default.

4. Has Congress always raised the debt ceiling?

Yes, whenever needed. According to the Treasury, since 1960 Congress has raised the debt ceiling in some form 78 times, 49 times under Republican presidents and 29 times under Democratic presidents. As shown in Figure 1, Congress has regularly raised the debt ceiling as needed. In fact, every president since Herbert Hoover has seen the debt ceiling raised or suspended during their administration.

5. Is the debt ceiling being raised to cover potential new spending programs?

No. Lifting the debt ceiling does not authorize any new spending. The debt ceiling needs to be raised to meet current obligations already authorized by Congress. Theoretically, not raising the debt ceiling would limit spending in the future, but only by deeply undermining the basic ability of the government to function, including funding the military, mailing out Social Security payments, and making interest and principal payments on its current debt.

While perhaps symbolic of excessive spending, the debt ceiling is not the appropriate instrument to limit spending. Spending responsibility sits with Congress and the president, but Democrats and Republicans have both favored deficit-financed spending once in power. Bill Clinton’s presidency, much of it with a Republican Congress, was the only one that saw the publicly held national debt decline since Calvin Coolidge in the 1920s.

6. When was the debt ceiling last raised?

The debt ceiling was last raised in December 2021. No Republicans voted for that increase, but some Republicans did vote to suspend the Senate filibuster so the increase could be passed with a simple majority.

7. If we were at the debt ceiling on January 19 and nothing happened, why is there a problem?

When we hit the debt ceiling, the Treasury is authorized to use “extraordinary measures” that allow the government to continue to temporarily meet its obligations, including suspending Treasury reinvestment in some retirement-related funds for government employees. But the additional funding available through these measures is limited.

8. What’s the actual deadline?

The real deadline, also called the “x date” is hard to pinpoint because it depends on revenue and payments that are variable as we approach the date. The level of tax revenue around the federal income tax filing date is particularly important. The window right now is wide, probably summer to early fall, but that does mean there are circumstances where the actual x date could be early summer.

9. Who typically wins debt ceiling battles?

Independent of anyone’s view on the level of government spending, a timely increase in the debt ceiling eliminates the risk of unnecessary turmoil for markets, businesses, and the economy. As for who wins the battle politically, we leave that for voters to decide for themselves.

10. What would the Treasury have to do if Congress failed to act in time?

Without the ability to issue new debt to pay existing claims, the Treasury would have to rely on current cash on hand (and incoming cash) to make its payments. So, the Treasury would be able to make some payments—just not all of them.  As such, the Treasury department would likely have to prioritize its payments. Moreover, the longer the delay in raising/suspending the debt ceiling, the harder it may be for Treasury to make its payments.

In 2011 and again in 2013, Federal Reserve and Treasury officials developed a plan in case the debt ceiling wasn’t addressed in time. At that time, they determined the “best” course of action would be to prioritize debt payments over payments to households, businesses, and state governments. By prioritizing Treasury debt obligations it was assumed the financial repercussions would be minimized. However, given comments by rating agencies (more on this below), there’s no guarantee that prioritizing debt payments would stave off severe, longer-term consequences like a debt downgrade or higher borrowing costs. Nonetheless, in order to adhere to the full faith and credit clause within the Constitution, debt servicing costs would likely be prioritized.

There is the possibility that prioritizing debt service would be challenged in court. Even if there’s a strong case to be made, we think debt service prioritization would be allowed to continue while the case works its way through the courts, since the potential economic damage would be too great otherwise. Even in the very unlikely event that Congress fails to raise the debt ceiling, the political and economic fallout would potentially be so swift that we would expect it to be raised in days rather than weeks or months, making the question of whether debt payments could be prioritized a moot point.

11. U.S. Treasury debt was downgraded in August 2011 because Congress waited until the last minute to raise the debt ceiling. Could we see additional rating changes this time?

In 2011, even though Congress acted before the x date, one of the three main rating agencies, S&P, downgraded U.S. Treasury debt one notch from AAA to AA+. While the other two main rating agencies retained the U.S. AAA rating, they both downgraded the outlook to negative. S&P has maintained that AA+ rating since 2011.

Now, all three rating agencies have publicly stated that they are confident a deal will get done. However, one of the three, Fitch, has threatened to downgrade U.S. debt if the debt ceiling isn’t raised or suspended in time. Further, Fitch has stated that prioritization of debt payments would lead to non-payment or delayed payment of other obligations and “that would not be consistent with an AAA rating.” So even if Treasury made debt payments on time, missing other payments would likely result in a rating downgrade. It is likely other rating agencies would follow suit as well. Another rating downgrade by a major rating agency would likely call into question use of Treasury securities as risk-free assets, which would have major financial implications globally.

12. Could failure to address the debt ceiling push the economy into a recession?

It would depend on how long Treasury would have to prioritize payments. If the delay is only a day or two, then it is unlikely the economy would slow enough to actually enter into a recession. Payments that were deferred would be repaid in arrears so the economic impact would likely be minimal.

However, in the very unlikely event that payment prioritization is necessary over a prolonged period of time—say a month or longer—this could indeed cause economic activity to contract. Since the government is running a fiscal deficit, and since Treasury cannot issue debt to cover that deficit, spending cuts would need to take place. The spending cuts, if prolonged, would likely push the U.S. economy into recession. Moreover, the unknown knock-on effects such as the impact on business confidence would also likely slow economic growth. Since the situation would be unprecedented, it’s very difficult to estimate the impact. Moody’s has said that based on their modeling, “the economic downturn ensuing from a political impasse lasting even a few weeks would be comparable to that suffered during the global financial crisis” (Moody’s Analytics, “Debt Limit Brinksmanship,” 6).

13. How would a technical default impact the financial markets?

In 2011, the S&P 500 fell by over 16% in the span of 21 days due to the debt ceiling debate and subsequent rating downgrade. The equity market ended the year roughly flat so investors who were able to invest after that large drawdown were rewarded. However, that large drawdown was due solely to the policy mistake of not raising the debt ceiling in a timely manner. It’s likely that if Congress were to wait until the last minute in raising/suspending the debt ceiling, equity markets would react similarly.

Perhaps counterintuitively, despite the prospects of delayed payments and the debt downgrade, intermediate and longer-term Treasury yields fell/prices increased as they are generally considered to be a “safe-haven” asset. And while that may have been the market reaction in 2011, there is no guarantee that in the event of a technical default and further rating downgrades Treasury securities would have a positive return this time around, particularly if Treasury securities lose their status as the risk-free rate.

Conclusion

Given the experience from 2011, we think it would be prudent for Congress to raise the debt ceiling reasonably in advance of the date when the government would no longer be able to meet all its obligations. Political brinksmanship with the debt ceiling is a dangerous game, with likely relatively little to gain and much to lose. At the same time, we don’t think that should hinder conversations about controlling spending. The debt ceiling simply isn’t the place for that conversation to take place.

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Soft landing or no soft landing, that is the question, with all due respect to William Shakespeare. But while this may be the most commonly asked question these days, it may not be the most important or the toughest. That honor goes to what’s priced in. Good market forecasts are not just about the economy and earnings—they are about what the market is pricing in. Below we share our thoughts on the potential for a soft landing, the possible role China might play in that, and whether markets are pricing in too much good news.

Strong Job Market Supports Case for Soft Landing

Recent economic and market data have reignited conversations about a potential soft landing. As we wrote in Midyear Outlook 2022: Navigating Turbulence, the ongoing economic recovery from the global pandemic required businesses and consumers to pilot the economy into a soft landing but that path would go through turbulence. As we subsequently developed Outlook 2023: Finding Balance, we thought the markets would be choppy as the world found its balance, while we waited for inflation to decelerate and central banks to ease up on their rate hiking campaigns.

So where are we in the business cycle? If you focus on jobs, the U.S. economy is headed toward a soft landing. Excluding the blowout report for January, average job gains were on a smooth downward trajectory (Figure 1). Minimal turbulence in the trend line is consistent with a pathway to a smooth landing. In fact, the blowout jobs report did not alter the Federal Reserve’s (Fed) playbook.

The unemployment rate was 3.4% as the labor market is still very tight—too tight for central bankers. But more importantly, wage pressures are abating. Growth in average hourly earnings continues to slow, easing down to 4.4% year-over-year in January.

Low participation rates continue to weigh on the minds of economists and investors, but it’s important to remember that business formation stats are consistently growing above pre-pandemic levels, revealing many workers’ interests in alternative employment and one reason why some of the workers remain out of the official labor force.

So bottom line here is the labor market is still solid, offsetting some risk of slower consumer spending. Additionally, the slowdown in average hourly earnings should ease inflationary pressures in the near term as wage growth comes back in line. No doubt the Fed will continue to increase rates at the next meeting to slow the demand side of the economy.

Consumers’ Debt Load Remains Manageable

As Figure 2 illustrates, consumers hold much less debt now relative to previous cycles. After the Great Financial Crisis, consumers started aggressively deleveraging. Overall debt payments as a percent of disposable income declined and remained steady until the emergence of COVID-19 and most recently, the debt service burden on the American household moved back up to pre-pandemic levels but still relatively low. The job market is tight, which means personal income growth is supporting consumer spending along with the accumulated excess savings. To further pad personal spending, consumers will likely tap into consumer credit. We expect revolving credit demand to increase in the first part of this year, but we don’t expect debt service payments to approach rates last seen in 2007 and 2008. This manageable debt load is a key component of the case for a possible soft landing.

China Reopening May Help

As the world’s second largest economy, China’s economy reopening could help prospects for the U.S. in 2023. The International Monetary Fund (IMF), which recently upgraded its global growth forecast for 2023 to 2.9%, listed China and India as economic “bright spots” contributing to nearly half of global growth for 2023. China is expected to expand by 5.2% as the stringent Zero-COVID-19 measures that hampered its economy during the pandemic have been lifted.

Similarly, global ratings agency Fitch recently revised its 2023 forecast for China’s economic growth to 5.0% from 4.1%, noting that “consumption and activity” are recovering at a faster pace than initially expected. The Purchasing Managers Index (PMI), an important indicator for growth, has already begun to reflect a sharp rebound in activity, with a jump from 41.6 in December 2022 to 54.4 in January 2023.

According to official government announcements and reports, consumer spending and support for private businesses are a top priority to help stabilize the sputtering Chinese economy. China’s debt-laden real estate sector is also a major area of the economy that is scheduled to be helped by government support, including lower interest rates to help property developers.

Chinese officials have embarked on a campaign to revive its longstanding trading relationships, with high level visits and talks with Europe and Australia. Despite difficult bilateral relations with the U.S., there are indications both countries seek to continue trade ties, as China remains an integral part of the global supply chain. In addition, U.S. companies have continued operations in China and expect their earnings to increase as the economy gains momentum.

For the global economy, China’s recovery and resilience should help underpin the broader worldwide recovery. The healing of remaining supply chain challenges will be an important factor in the normalization in global economic growth, as will the normalization of overall trade relations. If the U.S. is going to achieve a soft landing, China’s impact on global growth will likely be a meaningful part of it.

Is a Soft Landing Priced In?

The outlook for economic growth and corporate profits is always a good place to start when forming a view of the equity market, but that’s only the first step. Next we ask perhaps the tougher question—what’s priced in?

The simple way to answer this question is with a basic price-to-earnings ratio (P/E). On a trailing four quarter basis, the S&P 500 Index is trading at a P/E of 19, in line with the 30-year average. That suggests valuations are fair and that a soft landing, or short-lived, mild recession, is probably priced in. Earnings are a bit depressed, supporting higher valuations, but the challenging near-term economic outlook with still-high inflation and more Fed rate hikes forthcoming, perhaps argue against that. Upside risk to interest rates may also argue against that, though LPL Research sees manageable upside to yields this year from current levels at a 3.7% 10-year Treasury.

Interest rates are a powerful force in equity valuations as a lower risk alternative. Factoring in rates and calculating an equity risk premium (ERP, earnings / price vs. 10-Treasury yields) gives us a below-average valuation (Figure 3). The ERP of 1.6% is currently above (more attractive) the long-term average ERP of 0.9%, though it is one of the more expensive readings of the past decade, given the big jump in yields since summer 2020. 

So, do these higher valuations mean more downside risk for stocks? Not necessarily. The average bear market decline in a recession is about 29%. That includes all recessionary bear markets, including the really bad ones such as 2000–2002 and 2008–2009. Even if we get a recession this year, we simply do not expect it to be as deep as those two instances, suggesting the 25% peak-to-trough decline in the S&P 500 last year may have been sufficient to price in the risk of the current economic environment.

Another way to assess downside risk is to apply more of a typical recessionary haircut to valuations and earnings. Instead of 18–19 times $240 in 2024 (LPL Research base case assumptions), 16 times $230 in 2024 puts the S&P 500 at around 3,680 at year end (the index closed at 4,090 on Friday, February 10), seemingly a reasonable bear case scenario as laid out in our Outlook 2023: Finding Balance publication.

Evidence Investors Are Strongly Embracing Risk

Another way to assess what the market is pricing in is by looking at the strength in high-beta stocks year to date relative to their low beta (or low volatility) counterparts. Better returns for high-beta, or higher volatility, stocks indicate investor risk taking and, presumably, increasing odds of a soft landing. The strength of high beta stocks in January was the ninth best month out of the past 30 years (360 months), or higher than the third percentile. This suggests maybe the soft landing is priced in and any disappointment could result in some downside to stocks.

Bottom line, while we acknowledge downside risk to earnings in a recession scenario, the risk to valuations from further increases in interest rates, and the market’s increasing optimism based on where the biggest 2023 gains are so far, we expect the October lows to hold and see solid, double-digit gains for stocks in 2023.

Conclusion

The 14% move for the S&P 500 off the lows last October, despite the weakening earnings outlook, clearly tells us the market is pricing in a more optimistic outlook for the economy and corporate profits. But perhaps much of that move may be justified based on rising odds of a soft landing. Recent strength in the jobs market, while worrisome for the Fed, along with healthy consumer balance sheets and manageable debt loads, position the U.S. economy to potentially muddle through.

Valuations are fair by our assessment, not rich, and enable some upside potential as the market gains additional visibility into the potential resumption of earnings growth later this year and into 2024. LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC) maintains its overweight recommendation on equities and 2023 year-end fair value target of 4,400 to 4,500, based on 18.5 times 2024 earnings per share of $240.

Jeffrey Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Quincy Krosby, PhD, Chief Global Strategist, LPL Financial

Jeffrey Roach, PhD, Chief Economist, LPL Financial

The script has been flipped in 2023. Last year’s underperformers have turned into outperformers this year, driving the S&P 500 Index up over 5% this month. The pace and composition of the rally have left many investors skeptical over its sustainability, especially amid a lackluster earnings season thus far. Of course, the market is also forward-looking, with expectations for falling inflation and a less hawkish Federal Reserve (Fed) as we progress into 2023. And although the trajectory of the rally will likely slow, seasonal indicators point to a path higher for U.S. equity markets by year-end.

For background, market seasonality is premised on the adage of ‘history doesn’t repeat, but it often rhymes.’ The embedded assumption is the market exhibits seasonal patterns or cycles that ‘rhyme’ throughout history, or more specifically when prices move in a recognizable pattern that occurs with some degree of consistency over a specific timeframe. These patterns can last anywhere from several days to several years, each having its own tendencies unique to that period. For example, we are now in year three of the presidential cycle, historically the best-performing year for stocks across the four-year cycle. By no means is seasonality flawless, as pricing patterns are historical tendencies and not a guarantee of future results. Within LPL Research, we view seasonal data as one input, among many, into our decision-making process.

When various seasonal indicators tell the same story, the message becomes more powerful. The market is now on the cusp of receiving one of these ‘messages’ by potentially hitting a trifecta of seasonal indicators this month.

What are the components of the trifecta?

1. Santa Claus Rally: This seasonal pattern was first discovered by Yale Hirsch in 1972. Hirsch, the creator of the popular Stock Trader’s Almanac, defined the period as the last five trading days of the year plus the first two trading days of the new year. A positive Santa Claus rally signal occurs when the S&P 500 posts a positive return during this timeframe. For 2023, the S&P 500 was up 0.8% during this period, checking the box for a positive signal.
2. First Five Days: Hirsch also created the First Five Days indicator. This indicator is considered a warning system for the year ahead when the first five days of the year are negative. The S&P 500 finished the first five days of 2023 up 1.4%, checking the box for a positive First Five Days signal.  
3. January Barometer: Last but not least, Hirsch also created the January Barometer indicator and its popular tagline of ‘As goes January, so goes this year’ (positive January returns are historically associated with positive annual returns). A positive January Barometer indicator occurs when the S&P 500 posts a positive return in January. With the S&P 500 up over 5% this month as of Friday, January 27, a positive signal is expected.

When all three of these indicators are positive, such as this year, the January Trifecta has been hit (credit for the Trifecta indicator goes to Jeff Hirsch, Yale’s son who has continued his Stock Trader’s Almanac work).

Figure 1 highlights various return metrics for years when the trifecta indicator was hit for the S&P 500. For additional context, we also included year-over-year earnings growth for the index, along with whether or not the year included a recession.

Key Takeaways:

As you can see in the chart, the trifecta accomplished this month has historically led to some very strong returns. The S&P 500 has on average added 12.3% to a 4.6% January gain between February and December, bringing the average gain for these years to over 17%. This sounds like a big gain, and it is, but keep in mind the average gain in the third year of the four-year presidential cycle is 16.8%, and the average year following a down year is up 15%.

It also worth noting that with the broad market slipping nearly 20% last year, this gain still would not get the market back to the 2022 high set on January 3, 2022. Stocks enter 2023 much more attractively valued than a year ago—roughly 18 times forward (2023) earnings as compared to over 21 times forward (2022) earnings a year ago, based on FactSet estimates.

Steady Path to Gains

Finally, we also compared the monthly seasonality for trifecta years and non-trifecta years. Figure 2 highlights the returns across each scenario. While the strong January average returns during trifecta years decelerate in February, they do not historically turn negative. In fact, of the 31 trifecta years observed, all 12 months produced positive average monthly returns.

Conclusion

Stocks continue to climb the wall of worry despite mixed messages between technicals and fundamentals. Seasonality indicators, including the trifecta indicator, suggest the path of least resistance for the broader market is likely higher for the year ahead. And while the seasonality message is clear, the market still needs catalysts to climb higher. LPL Research believes the end of the Fed’s monetary policy tightening will be a key driver for stocks this year. Cooling inflation data will not only underpin a policy change, but also reduce headwinds for companies battling ongoing pricing pressures. The end of a rate hike cycle could also mean interest rate stabilization or even lower interest rates, another potential driver of equity market gains. Finally, while we believe recession risk remains high, there is the chance the U.S. economy is only facing a growth scare and muddles through on the back of a resilient consumer who is flush with cash. 

Adam Turnquist, CMT, Chief Technical Strategist, LPL Financial

Jeffrey Buchbinder, CFA, Chief Equity Strategist, LPL Financial