As we turned the calendars to March last week, it seems an opportune time to look at what has changed in the stock and bond markets in 2023 so far. The first change was that markets priced in peak future inflation in March 2022, and those expectations trended lower until late December. Recall that actual consumer inflation (CPI) peaked in June 2022 at 9.1% year-over-year and declined to 6.4% in January 2023. Markets sniffed out that inflation would be more sticky, and future inflation expectations have risen year-to-date.
While they didn’t move up precisely in unison with rising inflation expectations, U.S. Treasury yields have risen year-to-date after being close to flat for the fourth quarter of 2022. The 2-year and 10-year yields have increased to 4.4% and 4% after dipping to 4.1% and 3.4% in January, respectively. This rise in interest rates and inflation year-to-date coincided with rising first-quarter economic growth estimates.
The second shift was the breakdown in the relationship between yields and the outperformance of value stocks. In 2022, the outperformance of value stocks versus growth stocks followed the path of Treasury yields almost perfectly. So far in 2023, growth stocks have outperformed despite the rate rise.
The changing fortunes of growth stocks in the face of rising yields can be seen even more clearly in the ARK Innovation ETF (ARKK). This ETF lost a whopping 67% of its value in 2022 but is over 29% higher in 2023. ARKK focuses on companies with high expected future growth but not necessarily current profits. These types of companies should be more sensitive to higher rates as the expected cash flows are in the future.
Value stocks’ valuation remains at a discount to its historical relationship with growth, so it looks like an opportunity to fade this recent growth stock outperformance or at least not chase this growth trend. While growth does not always underperform when yields rise, the valuation seems to give an edge to the likelihood of value reemerging as a leader in this scenario.
Lastly, after U.S. small-cap stocks, as measured by the Russell 2000, underperformed the S&P 500 by over two percentage points in 2022, smaller stocks outperformed year-to-date in 2023. The Russell 2000 is almost 10% higher in 2023 versus nearly 6% for the S&P 500. While it is impossible to know if this trend will continue in the short term, it looks like an opportunity currently. The valuation of small-cap stocks relative to large companies is well below typical levels, which provides comfort that long-term returns could be attractive. Small-cap stocks are usually more susceptible to economic downturns, so implementation is crucial. The Russell 2000 contains many unprofitable companies, so investors should consider an investment vehicle that targets small companies with earnings. For example, the iShares Core Small-Cap ETF (IJR) and Avantis U.S. Small Cap Value ETF (AVUV) are attractive options with reasonable internal expenses.
While Fed Chair Powell speaks to Congress on Tuesday and Wednesday, he is unlikely to cover much new ground. Instead, the monthly jobs report on Friday has the makings of the more significant market mover. The resilient labor market remains at the heart of the concerns about inflation remaining more persistent than previously expected. It is hard to envision wages and hence services inflation softening significantly if unemployment remains low.
After the better economic data and elevated inflation readings, markets are pricing in at least three more short-term interest rate hikes of 25 basis points (0.25%) in March, May, and June. A stronger-than-expected jobs report on Friday could add additional expected hikes and send the one-year forward Fed fund futures rate to a new high. Further Federal Reserve rate hikes raise the likelihood of a future recession as the Fed might be forced to smother economic growth to curb inflation.