April 17, 2023

Despite a tumultuous March, the S&P 500 Index gained +7.0% in the first quarter of 2023. While equities may have started — and ended — Q1 on a high note, the net rise in stock prices doesn’t tell the whole story. Midway through the quarter, a confluence of market events and economic conditions conspired to create a temporarily turbulent environment for investors.

Here’s how these Q1 developments are likely to influence market dynamics in Q2:

Q1 in review: A brief look back

During the first several weeks of the new year, stocks trended positively, driven by the disinflation narrative, contrarian stock positioning after a brutal 2022, soft landing hopes for the global economy, China’s reopening theme, and a low bar for the Q4 earnings season.

However, as the quarter progressed, that stock momentum softened as underwhelming fourth quarter earnings reports materialized, strong U.S. labor trends persisted, and fears grew that tighter monetary policies and high inflation would eventually send the U.S. economy into a recession.

Most notably, the unexpected banking crisis in March upended investor and consumer confidence as the quarter was winding down, increasing already elevated recession risks. By the quarter’s end, however, banking fears subsided as regulators intervened and deposits stabilized. In the final weeks of the quarter, stocks staged a modest rally. Most major U.S. averages finished March higher, with the late-quarter rally helping to pad Q1 gains.

Q2 outlook: 5 key themes for investors

Where do equities go from here? As the second quarter begins, here are key themes for investors to keep in mind:

1. Bad news for the economy is likely bad news for stocks. 

Unlike earlier in the year, when data pointing to a slowing economy was good for stocks because it was likely correlated with the Federal Reserve slowing rate hikes, data pointing to a slowing economy today suggests weaker demand, lower profits, and deteriorating economic conditions. Conversely, employment trends that remain robust/firm (especially if inflation stays elevated) could entice the Federal Reserve to tighten monetary policy further or leave rates higher for longer. This could place additional strain on the economy and/or lead to a deeper recession, which would weigh on corporate profits. Bottom line: investors should not discount the mounting risks facing equities today.

2. Evolving conditions across the banking sector will likely be a primary focus for investors in Q2. 

Investors should expect credit conditions to tighten across all banks, possibly significantly in some cases (e.g., smaller regionals). Tighter lending standards, reduced access to credit, and a more conservative stance among large/mid-sized banks, could lead to smaller-than-expected profits across the financials sector over the coming quarters. In addition, these evolving banking dynamics may produce unforeseen knock-on effects across businesses, large and small. Importantly, regional banks are the lifeblood of the U.S. economy. As a result, a slowdown in the banking sector should be expected to filter through to the broader economy over time.

3. Inflation and the Fed are still top of mind.

Market odds currently suggest the Federal Reserve will lift its fed funds target rate higher by 25 basis points in May to 5.00% - 5.25%. But by the end of July, a majority of market participants believe the Fed funds rate will be at or lower than where it stands today. Similarly, most of the market sees inflation continuing to ebb lower as supply chains normalize, demand decreases, and labor conditions moderate. But we would stress there is still a significant disconnect between current Fed messaging on the path for rates and the market’s view on forward monetary policies. Given inflation is still over 2x the Fed’s longer-term target, stocks could see more volatility in Q2 if the Fed remains on point with their higher for longer messaging. And if the market is correct, and the Fed needs to cut rates in the second half, it’s likely because growth/inflation is deteriorating faster than expected. Neither scenario is a very friendly environment for stocks, in our view.

4. Stocks have competition.

Government bonds, investment-grade credit, CDs, money markets, and other short-term fixed income/cash-like investments offer competitive returns for less risk than stocks. Given a still highly uncertain environment, investors may gravitate toward safer investments in Q2, limiting near-term momentum in stocks. That said, most investors should balance portfolios with the desire for safety/return of principal and the need for longer-term growth opportunities. While a focus on quality companies with predictable revenue streams, strong balance sheets, and income generation could help mitigate volatility, potential stock weakness (should it occur) should be viewed as an opportunity to acquire good long-term businesses at a discount, in our view.

5. Don’t forget about the profit picture.

Unfortunately, the view isn’t great. The financials sector typically kicks off each earnings season, and the market will likely be acutely focused on what this group says about profit trends, lending conditions, and evolving banking dynamics. Notably, Q1’23 S&P 500 earnings per share growth is expected to decline by 6.8% y/y and by 4.2% in Q2. Unfortunately, we believe back-half estimates may have more room to adjust lower depending on how economic, inflation, and banking conditions evolve over the coming months. Bottom line: Stock volatility may remain elevated, particularly during the earnings season when corporate America provides a peek into business conditions across a variety of industries.

Lean on your financial advisor for personalized guidance

If you have any questions about how present market conditions may affect your unique situation, reach out your Ameriprise financial advisor. They provide personalized insight into your portfolio’s performance and help you make adjustments in the event that your risk tolerance, time horizon or financial goals change.