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Markets and the economy survived a tough first quarter, but it’s not going to get any easier

The economy and stock market head into the second quarter facing both headwinds and tailwinds, with investors left to sort it all out after an unexpectedly strong start to the year. Despite peaks and valleys, stocks closed the first quarter on an up note, with the S & P 500 rallying more than 7% and the tech-fueled Nasdaq soaring about 16%. At the same time, the economy is expected to book solid gains of its own, with one tracker indicating a GDP increase around 2.5% and inflation showing tepid signs of easing. But danger lies ahead. No one is quite sure how bad the crisis in banking will get. The Federal Reserve seems committed to its inflation fight even as markets expect interest rate reductions in the months ahead. Finally, corporate profits are slated to post their worst quarter since the early days of the Covid pandemic. Investors are left to navigate a brittle landscape. “You have to call it your textbook tug-of-war between price action and the wall of worry,” said Quincy Krosby, chief global strategist at LPL Financial. “With all the headlines, with all the worries embedded in those headlines, how is it that the market has held up?” .SPX .DJI YTD line S & P 500 gains so far in 2023 Indeed, the market has lived through a lifetime of scary headlines in the first three months of 2023. Whether it was heightened inflation worries at the Fed, continued expectations for recession from economists, or the failure of one of the nation’s biggest banks sparking fears of another 2008-style financial crisis, investors have had to climb more of a Mt. Everest of worry than a wall. Yet the market has had an uncanny knack for looking at the bright side of things. Despite repeated protestations from Fed officials that they are taking the higher-for-longer approach on interest rates, markets still expect cuts. A tough outlook for earnings and thousands of layoffs from the tech sector have not thwarted the aforementioned rally in the Nasdaq. And even bank stocks are beginning to stabilize after getting slaughtered in the wake of the SVB failure. End of the bear? There are also some technical indicators that markets are in recovery mode. The S & P 500 didn’t closed below its December low in the first quarter, something that has happened 36 times, with stocks down only twice in the ensuing year, according to Ryan Detrick, chief market strategist at Carson Group. Quarterly Investment Guide ETF outlook: Why Wall Street strategists aren’t chasing a growth stock trade just yet It’s been said that bear markets end on bad news — that is, when dark headlines no longer scare off investors, it’s safe to assume that all the downside has been priced in and stocks can move higher. That could be the case now as well. “I’m actually more optimistic than most people you’ll talk to. Equity markets have held in incredibly well,” said Mark Hackett, Nationwide’s chief of investment research. “The news is not dinging the market in any meaningful way or for any extended period of time. That’s generally the type of behavior you see as you’ve passed the worst and are headed for recovery.” One knock on the current move higher is that it’s being powered by just a handful of stocks. Apple, Nvidia and Microsoft have led the way across the major indexes, with Salesforce and Facebook parent Meta also contributing to gains. AAPL .SPX YTD mountain Apple compared to the S & P 500 Only five of the 11 S & P 500 sectors are positive for the year, despite the substantial rally for the index. That lack of breadth has market bears worried that the gains so far are unsustainable. Interestingly, though, Hackett said he thinks investors would be best off forgetting about the early leaders out of the gate and focusing elsewhere. “The valuations in that space are still pretty elevated and the earnings risk there is still pronounced. For me, I’d look almost anywhere else beyond that. I like small-caps,” he said. “What’s your best risk-reward bet? I think it’s out of the safe haven of large growth.” However, large-cap tech is not the only area of earnings risk. S & P 500 profits are expected to decline 6.6% from a year ago, which would be the biggest slide since the second quarter of 2020, when corporate America is in the throes of the pandemic, according to FactSet . That would follow a 4.6% drop in Q4 of 2022 and qualify as an earnings recession. The net profit margin for the S & P 500 also is expected to edge lower to 11.2%. Technology is forecast to post a 15% plunge, third-worst behind materials (-35.9%) and health care (-20.5%). Waiting on a recession That trend down comes amid expectations that the economy could slide into a highly telegraphed recession later this year. The only question now seems to be how deep the contraction will be. “The bond market is pricing in disinflation and recession and the equity market simply is not,” said Joseph Brusuelas, chief economist at RSM. “So if you do get that margin compression, that doesn’t bode well for equity prices heading into the middle of the year.” Brusuelas does expect a recession to hit around mid-year, fueled by a credit crunch spillover from the banking crisis. “We still see elevated financial stress in the market. My sense is that the worst of it is behind us,” he said. “We’re going to have a series of one-offs, perhaps a dozen or more (bank failures). I doubt that will cause a freezing up of credit, as opposed to contractions and tighter lending.” The Atlanta Fed’s GDPNow tracker is indicating a 2.5% annualized growth increase in the first quarter, though that number has been trending lower lately. All about policy Of course, lurking above everything is the Fed. The central bank has boosted its benchmark interest rate 4.75 percentage points over the past year, but signaled in March that it is nearing the end of its hiking cycle. Markets, however, see not only an end in increases but also cuts before the end of the year. Rate decreases likely would be used in the event of a recession that the bond market has been signaling for months. The 10- and 2-year Treasury yields inverted last year, a surefire sign of a looming recession. As if on cue, the inversion has eased in recent weeks, also a textbook sign that recession is coming as yields fall in anticipation of Fed rate cuts. US2Y US10Y 1Y mountain the 10-year and 2-year Treasury yield curve The anticipation that the Fed soon will ease “goes a long way to explaining why equities remain resilient,” Nicholas Colas, co-founder of DataTrek Research, said in a recent market note. “No one wants to miss the start of the next easing cycle. Could Treasuries be wrong this time? Of course. But the default scenario baked into asset prices is based on the Fed pivoting – quickly – to lower policy rates.” That’s a big gamble for both the economy and the markets. Corporate CEOs responding a recent Richmond/Atlanta Fed survey done in conjunction with Duke University indicated less fear of a recession than before. But that taken just before the banking problems. A tougher Fed could mean a continued squeeze on bank lending — watch the May 1 release of the Fed’s senior loan officer survey as one of the biggest under-the-radar data points of the quarter — while a looser central bank might only come if the economy is in serious trouble. Either could force a big unwind in the early-year rally. “The wall of worry seems to get taller, and the price action is looking at the wall of worry and saying what exactly are you so worried about?” said Krosby, the LPL strategist. “Were careful. We’re still in the camp of just being prudent.”

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