A new year has brought with it a new set of questions for investors, as the economy kicked off 2023 with more momentum than expected while rising stress in the regional banking system led investors to question whether the probability of recession had increased. We acknowledge that the risk of recession has risen relative to the start of the year, particularly as the Federal Reserve (Fed) looks set to continue their rate hiking campaign in the near-term and bank lending standards tighten. Against this backdrop, however, interest rate volatility has risen but equity markets have been relatively well behaved. So, what mattered to the stock market during the first quarter?

The bottom line is that performance in U.S. equity markets so far this year has been all about rates, a theme that should persist as earnings expectations gradually align with reality.  From a style and size perspective, we seem to have temporarily returned to a world where large cap growth is the belle of the ball; the first quarter saw growth handily outperform value, and large caps meaningfully outperform small caps. Taking this a step further and decomposing performance into the underlying drivers helps us understand why; the majority of the return from growth stocks, large caps and small caps was driven by an increase in valuations, as interest rates declined on the back of expectations for a more dovish Fed later this year. Meanwhile, earnings expectations fell across the board; the decline in earnings expectations for growth stocks was fairly benign, but particularly acute in small caps, offsetting nearly all of the multiple expansion enjoyed by smaller companies. Value saw more muted performance as valuations only expanded modestly and earnings expectations declined.

Valuations will continue to be driven by expectations for interest rates, which appear too dovish in our view. Meanwhile, earnings estimates are likely to continue their decline, particularly across the more cyclical sectors. This warrants a cautious approach to equity markets focused on quality and cash flow - defensive value names and profitable growth names seem to fit the bill. However, it will be important for investors to pay attention to the price they are paying for these exposures, as elevated valuations are likely to decline as markets recognize that aggressive monetary easing is not on the near-term horizon. 

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