Goodbye and Good Riddance to 2022; 2023 Starts Off on a Positive Note

HIGHLIGHTS:

• Stocks and bonds both gained in January, a welcome beginning to the new year after a tough 2022 – a year that saw stocks have their worst results since 2008 and bonds have among their worst results ever.
• As stocks advanced in January, volatility, as measured by the VIX Index, dropped lower – closing at a 52-week low of 17.97 on January 27th. It closed the month at 19.40 after ending 2022 at 21.67.
• The 10-year U.S. Treasury yield ended 2022 at 3.88%. Continuing the general trend since its peak of 4.25% in late October, the yield moved lower in January and closed the month at 3.52%, creating a better backdrop for bonds.
• The 10-year U.S. Treasury yield ended November at 3.68%, but rates rose to close out 2022 at 3.88%. As a reminder, the 10-year yield ended 2021 at 1.52%.
• The FOMC raised rates at its first FOMC meeting of the year on February 1 by 0.25% as expected. The “step down” in rate hikes continues, and we believe we are in the late innings of this rate hike cycle.
• Economic data continued to be mixed with continued solid job market data, but other areas of the economy showed signs of weakness. On a positive note, the initial estimate of Q4 GDP showed a gain of 2.9% on an annualized basis – supporting the idea that the economy rebounded in the second half of 2022.

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EQUITY MARKETS

Equity index returns for January were as follows: The S&P 500 gained 6.28%, the Dow Jones Industrial Average rose by 2.93%, the Russell 3000 advanced 6.89%, the NASDAQ Composite rallied 10.72%, and the Russell 2000 Index, a measure of small-cap stocks, gained 9.75%. January was in many ways a mirror image of 2022 — growth stocks rallied sharply, and small-caps outpaced their large-cap counterparts to start 2023.

We will wait to see if this change in leadership develops into more of a trend after large-cap value stocks dominated on a relative basis last year. The VIX Index hit a 52-week low in late January (at 17.97 on January 27th), which came as equities enjoyed solid progress during the month. (A new 52-week low was put in on February 1 as markets rallied following the FOMC meeting with a rate increase of only 25 basis points). The VIX Index closed 2022 at 21.67.

Equity strength was widespread in January. However, showing the surge in growth stocks, the large-cap focused Russell 1000 Growth Index gained 8.33% for the month after it was off – 29.14% for 2022. The Russell 1000 Value Index advanced by 5.18% in January after being down a more modest –7.54% in 2022. Growth stocks are sensitive to interest rate moves and higher interest rates dominated most of 2022.

However, rates have moved lower in recent months, and they fell further in January, which helped growth stocks during January. Market cap size was more important than style (value versus growth) in the small-cap universe. The Russell 2000 Growth Index rallied 9.95% in January while the Russell 2000 Value Index advanced 9.54%. Growth had a modest edge to value in small-caps, but small-caps overall outperformed their large-cap counterparts in January.

We at Clark Capital continue to use our disciplined approach of seeking out high-quality companies with improving business conditions at what we believe are good prices and those companies can be found in both the value and growth universe as well as various market cap levels.

International stocks continued their recent rebound in January. As we often discussed in 2022, the U.S. Dollar Index (DXY) broadly strengthened during most of the year, but it was relatively flat in December after declining sharply in November. The U.S. Dollar Index continued to slide lower in January, which again was a positive tailwind for international stocks. The MSCI ACWI ex USA Index, a broad measure of international equities, gained 8.11% in January, while the MSCI Emerging Markets Index rose by 7.90%. Reflecting their strength in recent months, these index returns for the last three months were 19.97% and 22.16%, respectively. As we have repeated many times, we believe international stocks are an important asset class for most high net worth investors.

Fixed Income

Following a dramatic year of interest rate increases, which led to one of the worst years for bond returns on record in 2022, yields continued their recent move lower in January. The 10-year yield closed 2022 at 3.88% and fell to 3.52% by the end of January. After closing on 10/24/22 at a more than 10-year high of 4.25% — a level not seen since the credit crisis — yields have moved lower.

As we have previously stated, we believe the move higher in rates in 2022 has run its course at the longer end of the yield curve and we expect the 10-year yield to move lower as we go through 2023. While bond returns were negatively impacted by rising interest rates last year, future potential returns for bonds have become more attractive with the higher yields available. As has happened in previous Fed rate hike cycles, longer rates have started to come down before the Fed has stopped raising the federal funds rate.

Bonds struggled in 2022 as there was a repricing of interest rates across the yield curve and across bond sectors as inflation spiked and the Fed began its aggressive rate tightening cycle. We maintain our long-standing position favoring credit versus pure rate exposure in this interest rate environment. We also believe that the role bonds play in a portfolio, to provide stable cash flows and to help offset the volatility of stocks in the long run, has not changed. Although 2022 was a struggle for bonds, the fourth quarter brought returns and 2023 has started out on a solid note across fixed income sectors.

Economic Data and Outlook

Job market strength continued in December. Non-farm payrolls increased by 223,000 in December when expectations called for only 205,000. The unemployment rate dropped unexpectedly to 3.5% when a reading of 3.7% was anticipated. This unemployment rate matches a post-pandemic low. Wages climbed as well by 4.6% on an annual basis, but this was not as much as anticipated with expectations calling for a 5.0% increase. Fed action is expected to raise unemployment, but Fed rate increases so far have not resulted in significant weakness in the job market. With the pace of wage growth slowing, that is likely being viewed positively by Fed officials.

Typically, the unemployment rate starts to rise heading into a recession, but there continues to be millions more job openings than job seekers — a key driver of wage increases. Although job openings had been moving lower, the JOLTS reading on job openings surprised to the upside in December. Over 11 million job openings were reported in December, when only 10.3 million openings were expected. Technology companies have made a lot of noise lately with their layoffs, but that trend does not seem to be spreading more broadly into other areas of the economy at this point. Ultimately, the job market is important to track with about 70% of U.S. economic activity driven by consumer spending, which remained resilient during most of 2022.

Housing continues to be impacted by higher mortgage rates and data reflected this general slowing theme. Building permits, considered a leading indicator for housing, declined in December. The reading showed an annualized pace of 1.33 million permits, but that was below expectations of a 1.365 million rate and the prior month of 1.351 million. Housing starts and existing home sales surpassed estimates, but both came in below November’s levels.

New home sales surpassed estimates and improved from a November number that was revised sharply lower. Recently, we have seen some monthly drops in home prices for the first time in years, but on an annual basis values are still higher. Based on the year-over-year reading of the S&P CoreLogic CS 20-City Index, home prices rose by 6.77% in November, but this continues the trend of slower price gains over the last several months.

Clearly, the rise in mortgage rates overall in 2022 and still high home prices have taken some steam out of the housing market. However, longer end interest rates have been coming down in recent months and home price increases have slowed dramatically, so hopefully those pressures will start to subside in 2023. The housing market has been a source of strength in the economy and has historically been a good leading indicator as well. Higher mortgage rates, high home prices, and an aggressive Fed slowing general economic activity are all headwinds to housing and home activity will likely slow further as the broader economy likely slows down in 2023.

December marked the second month in a row that the ISM Manufacturing Index was below 50. At 48.4, the reading was a slight miss from estimates at 48.5 and lower than the November mark of 49.0. This lower trend continued in January as this index dropped to 47.4 compared to expectations of 48.0. The new orders component of this reading continued to move lower to 42.5 in January compared to the prior month of 45.1.

The ISM Non-Manufacturing Index, which covers the much larger service industries in the U.S. economy, dropped sharply and surprisingly in December. Expectations were calling for a reading of 55.0, but instead, the number dropped to 49.6. This was such a sharp drop that we will monitor the next month’s reading closely to see if the December number was “noisy” for some reason. Recall that ISM readings above 50 indicate expansion and below 50 signal contraction.

Manufacturing had been moving rather steadily to contraction territory, but services had shown relative strength over the last several months until this dramatic drop in activity in December. In our opinion, one month is not a trend, so we want to see how the service data comes in over the next few months as well.

Retail sales (ex. auto and gas) showed weakness in December, dropping by — 0.7% for the month when no change was expected. The preliminary University of Michigan Sentiment reading for January was better than expected and improved from December — not too surprising with stock market strength in Q4 and January and ongoing moderation in inflation.

The Conference Board’s Leading Index continued to decline and fell by — 1.0% in December, when the decline was expected to be — 0.7%. The first reading of Q4 2022 GDP came in on a positive note at a 2.9% annualized pace when a 2.6% rate was expected. The economy weakened in the first half of 2022, but it rebounded solidly in the second half of the year. We believe that economic momentum will continue into the first part of 2023; however, we acknowledge the risk of a mild recession has increased and believe it is about as likely as a soft landing.

The strength in the labor market and improvements on the inflation front balance out the negative of the 3-month T-Bill and the 10-year U.S. Treasury rate inversion that occurred in late October — historically an indicator that the economy might be headed toward a recession. This inversion is now coupled with ISM readings below 50 and leading economic indicators that continue to weaken.

We believe that we are in the later innings of this Fed rate hike cycle and the Fed slowed the pace of rate increases once again at the February 1 meeting to a 25-basis point hike. The Fed continues to tell the market to expect rates to stay higher for longer, but following the February 1 meeting, the tone of Chairman Powell seemed less hawkish.

Inflation remains elevated, but progress on the inflation front has been made. The headline Consumer Price Index dropped to 6.5% in December on an annual basis from 7.1% in November, well off its high of 9.1% last summer. The core CPI reading dropped from 6.0% to 5.7%. The headline Producer Price Index dropped to 6.2% in December, below estimates of 6.8% and the revised lower reading of 7.3% in November. The Fed has seen enough improvement occurring on the inflation front to at least throttle down the pace of rate hikes. The course of Fed action in 2023 will still be of critical importance to the market, but the first meeting in 2023 with a 25-basis point increase (and a less hawkish Chairman Powell) was at least initially well received by the market.

The Fed’s aggressive rate hikes clearly impacted capital markets and the economy last year. Markets reset valuations based on higher interest rates and lower corporate earnings expectations in this rate-tightening cycle. However, we believe we are in the late innings of this rate hike cycle and we expect the Fed will likely raise rates one more time in March before pausing.

Although economic growth picked up in the second half of 2022, we expect growth to continue early in the new year and slow later in 2023. We also believe the odds of a mild recession are about 50/50. However, the job market has remained resilient and is a critical component of our overall economy, leading us to the conclusion that any economic slowdown would be modest.

Importantly, stocks and bonds have historically hit their lows early in the rate hike cycle, well before the Fed has made its final rate hikes and we believe those last rate hikes are coming soon. As always, we believe it is imperative for investors to stay focused on their long-term goals and not let short-term swings in the market derail them from their longer-term objectives.

Investment Implications

Clark Capital’s Top-Down, Quantitative Strategies

Our tactical top-down strategies maintain their risk-on positioning with credit very firm as financial conditions ease in the face of Fed tightening. Market breadth has been strong with broad participation and leadership developing in small and mid-cap stocks. We are also seeing strength across sectors that normally perform well in the early stages of bull markets including semiconductors, consumer discretionary,
and homebuilders.

Clark Capital’s Bottom-Up, Fundamental Strategies

In our bottom-up portfolios, we continue to seek out what we believe are undervalued, high-quality companies in both developed and emerging markets. Growth stocks may narrow the performance gap relative to value, but we expect traditional quality metrics including valuation, free cash flow, earnings growth, and revenue guidance to perform well.

ECONOMIC DATA

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