Key points
- After a difficult 2022 for investors, the U.S. equity market narrative has turned more positive in 2023. However, this positivity feels premature, in our view.
- The equity risk premium currently available from the U.S. equity market is around historically low levels, which makes for a disappointing risk/reward profile.
- Stock selection will likely drive near‑term U.S. equity returns. An all‑cap remit provides the flexibility to find alpha sources from across the entire market.
After a difficult 2022 for investors, the narrative in the U.S. equity market has turned more positive in early 2023. This is largely due to expectations of cooling inflation, which will allow the Federal Reserve to pull back on aggressive interest rate hikes. However, with much that remains uncertain, this positivity feels premature, in our view. There is no denying investor sentiment has become more fragile over the past year. Stocks leading the market are changing at an unusually fast pace, regardless of fundamentals, making it more difficult to find reliable sources of alpha. On a risk/reward basis, the U.S. equity market also looks broadly expensive, in our view, meaning performance is likely to be driven by individual stock selection. This is where an all‑cap equity remit can be beneficial, providing the flexibility to find potential sources of alpha from across the entire market and the broad diversification to better manage risk and potentially deliver more consistent performance outcomes.
Taking Stock of the Current Landscape
Consensus opinion has turned more positive since the start of 2023, with expectations that inflation has peaked, thereby enabling the Federal Reserve (Fed) to stop raising interest rates later this year. However, we do not feel a whole lot has changed since 2022. The rise in inflation has been fuelled by structural changes in the U.S. economy; and while it is indeed receding, we anticipate the path back down toward the Fed's 2% target will be a much more drawn‑out process than the consensus appears to believe. If we look back to the late 1970s and early 1980s, when inflation was similarly elevated, history tells us that the disinflation process tends to be slow and drawn out, especially when similar inflationary trends are observable in other major regions. As such, we believe that—unless there is a recession—U.S. inflation could take much longer to get down to target level than the consensus currently expects.
History also argues that a deeply inverted yield curve makes recession difficult to avoid. However, the longer an economic landing is delayed, in the hope that it can be avoided altogether, the harsher the landing is ultimately likely to be. What seems to be underappreciated, in our view, is that we have entered a new investment regime, and there is a great deal that remains uncertain. Adjusting to this new landscape will take time and be potentially uncomfortable along the way.
Investors' more positive outlook in early 2023 sparked a sharp rotation in the equity market, with more cyclical, growth‑oriented companies rallying strongly, notably led by beaten‑down technology, consumer discretionary, and industrial stocks. More recently, investors have applied the brakes to the market, seemingly wary after such a strong start to the year.
This post was funded by T. Rowe Price
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