Head of FX Strategy
Summary: Large cap stocks, especially in tech, have seen big gains in the last few weeks primarily due to the slide in Treasury yields and flight to safety amid the banking sector woes where companies that are less dependent on financing needs become attractive. How long that outperformance can continue is a question, given that tech stocks are not immune to a growth slowdown. But more importantly, small cap stocks will likely continue to be under pressure if bank lending standards tighten and a recession becomes imminent.
The first quarter of 2023 has been quite a turn from last year. The S&P 500 ended 2022 down close to 20% but is up 3% YTD while the NASDAQ100 ended 2022 with declines of over 30% but is now up 17% YTD. This may be unexpected as the macro situation looks far more vulnerable, with 2022 seeing inflation risks remaining top of mind, but the banking sector troubles have added to that recently and raised the risks of a credit crunch leading into a recession.
Part of the reason for the sustained stability in equities has been the slide in Treasury yields as Fed rate hike bets have been pared quickly. But this is potentially a sign of short-sightedness, where investors are focused on a dovish turn in Fed policy but still not ready to price in the threat of a recession that could take the equity risk premiums higher even as lower interest rates help to improve the valuations.
Another key reason has been positioning, where many investors had scaled back their exposures last year and in the run upto the collapse of SVB earlier in March. This lowered the rate of exodus from the markets as the new crisis hit. Meanwhile, sentiment has been supported so far with the regulators announcing quick measures even as uncertainties linger and risks of further fallouts in the financial sector remain.
A more micro trend evident YTD has been the outperformance of the large growth stocks, and that is also what is driving key indices higher YTD. Market breadth is reducing as large-cap stocks outperform and drive broader indices higher, but beneath the surface, a larger number of mid-to-small cap stocks continue to decline. Apple and Microsoft have climbed 23% and 17% respectively YTD. Google parent Alphabet is up 20% as well, while Meta is up 71% after a decline of 64% in 2022.
The reason for tech outperformance once again partially comes from lower yields, as these companies are usually more interest rate sensitive and scaling back of Fed rate hike bets has been boon to the high-growth tech sector. The companies have also been leading cost management, with massive layoffs being announced since late last year, and may be able to deliver better-than-expected earnings for the first quarter.
Meanwhile, small cap stocks are being disproportionately hit by concerns that problems in the banking sector would lead to a credit crunch, making it harder to borrow money from banks and operate their business models. In contrast, the megacap companies are generally less reliant on credit financing given the large amounts of cash on their balance sheets. So the flight to quality in terms of the emanating credit risks has brought the large cap tech stocks in favour. Risks of bankruptcies is likely to go up if bank lending standards are tightened, and that could mean continued pressure on small caps.
There may be some room to run for this outperformance of tech stocks, especially if you think the Fed could start to signal rate cuts. However, the tech sector is not immune to a growth slowdown. Even if these companies manage to report a strong Q1 earnings, the outlook could take a turn for the worse in light of the increasing recession risks. Not to forget, most of these large tech companies are still over-staffed after massive hiring sprees during the pandemic.
Investors should also be nimble to assess their portfolios, given the outperformance in large caps could alter their desired asset allocation. Say if a cautious investor wanted to maintain an overweight to value stocks vs. growth stocks. The major rally in growth stocks may have shifted the allocation to be in favour of growth, and portfolio allocation therefore may need to be revisited.
Long-term investors also need to keep an eye out on the tangible vs. intangible trend, given that the global supply-side vulnerabilities have still not been resolved and that will continue to emphasise a need for productive investments in the next few years.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
