In this episode of Markets in Focus

Inflation was the dominant story for the market in 2022, but not the only story. Beneath the surface, factors such as growth vs. value often shifted rapidly, temporarily altering the character of the market. Steve Singleton, Head of Portfolio and Investment Risk at Raymond James Investment Management, and Peter M. Schofield, CFA, Senior Portfolio Manager for Chartwell Investment Partners’ Dividend Value Strategy, discuss whether 2023 could bring more of these inflection points and why – plus how investors can leverage factor investing to navigate market volatility.

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Transcript

Matt Orton:
2022 was truly a one-dimensional year where the persistence of inflation dominated nearly everything else. We saw the sharpest rise in lending rates across any tightening cycle since the late 1970s, and other composite measures of financial conditions also tightened significantly throughout the year. It's not surprising, then, that both equities and bonds were incredibly challenged. But what really stood out to me is the elevated level of volatility, particularly in fixed income, as well as the rapid changes in sentiment that took place around updates from the Fed.

Beneath the surface, we've also seen rapid shifts in the factors underpinning the market leading to a number of what I would describe as inflection points, where the character of the market shifted. But none of these inflection points have proven to be durable – yet – and we may be in for more of these shifts until we have more clarity on the ultimate destination for rates. The good news is that we're getting closer to that point. And it's also worth highlighting that despite the rapidly changing underpinnings of the market, there have been some durable themes and factors that consistently worked last year in 2022.

But can we count on them working if we come to another inflection point in 2023? And how should we think about navigating those inflection points? At the end of the day, being on the right side of these inflections is really where alpha can be meaningfully made or lost. And to help with that, I've asked Steve Singleton, head of portfolio and investment risk at Raymond James Investment Management, as well as Pete Schofield, senior portfolio manager on Chartwell Investment Partners’ Dividend Value Strategy, to join us today, specifically to provide color on some of the factors that have and haven't been working beneath the surface and how they think about navigating volatility and key inflection points.

This is Markets in Focus from Raymond James Investment Management. I'm your host, Matt Orton, and I invite you to join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. Steve and Pete, thanks for joining today.

Pete Scholfield:
My pleasure, Matt.

Steve Singleton:
Great to be here.

Matt Orton:
All right, we can all agree that the past year has been pretty one-dimensional from the top, but there's a lot happening beneath the surface, and I don't think this ever gets enough airtime in the market narrative. Before we begin, Steve, maybe from a high level you can start simply by discussing what and why factors matter, how can it be leveraged in alpha generation and to help navigate volatility?

Steve Singleton:
Sure, Matt. Factors provide a lens of clarity into what the market's reacting to on any given day, including intraday and associated longer extended periods. The continual decade-long integration of technology and finance has brought us to this point in a journey where concepts such as efficient markets and the efficient market hypothesis are now tangibly played out on trading floors every day and serve as underlying pillars driving public market investing. For public equities in particular, investors can very easily access any portion of these markets as all benchmark stocks are in at least three, if not four ETFs, and that would be size, style, sector, or theme, and in some cases, various themes. With that as a backdrop, it creates a very clear opportunity to utilize some of that technology to combine fundamental disciplines and diligence with quantitative acumen to exploit the volatility present and identify durable and sustainable alpha trends by accessing or avoiding certain factors in play.

Matt Orton:
Thanks, Steve. I think, that's a great setup for Pete, because I'd love to hear from a portfolio manager how you think about managing portfolio risks, particularly around some of the multiple double-digit market moves that we had in a year like last year.

Pete Scholfield:
You don't necessarily see this kind of volatility coming. But when it occurs, I think it's most important to be flexible and opportunistic and to not let your portfolio positioning get too one-sided. These market swings don't have to be our enemy. In fact, we can take advantage of them by seizing the opportunity to buy a stock that's been on our watch list, for instance. Maybe we were just holding out for better valuation, and similarly for trims or sales from our current holdings where we were waiting for a better price. I'd also add that a volatile market often gives active managers a chance to shine if you can be nimble, whereas a straight upline market probably gives some advantage to passive approaches.

Matt Orton:
I think that's a great point, Pete, because finally for the first time really since 2007, we actually saw active managers do well last year, which is a welcome relief and on a risk-adjusted perspective, too, like you pointed out, active management actually begins to matter when you have these moves. Now, that we've got some background, Steve, maybe you can talk about what has worked and hasn't worked last year from a factor perspective. Even within factors, there's been a lot of volatility. But at the same time, I know there's been some that have consistently been in and out of favor.

Steve Singleton:
In our risk group, we talk a lot about the 2022 trade or strategy as one that was long the value, momentum, quality, yield, and profit factors. These were the factors that largely performed well and led the year. Portfolios with positive active exposures to these factors — and active exposure being portfolio minus benchmark — typically outperformed their associated benchmarks by a margin with lower volatility.

What struggled this year was the other side of that trade, where you found stocks with no earnings or lower quality or negative or downward momentum. These are characteristics that were typically consistent with longer-duration growth stocks. Not necessarily bad concept stories, just no near-term visibility into earnings at a time when rates were undergoing a powerfully persistent multi-handle rise.

Matt Orton:
As a follow-up, Steve, maybe you could provide some color on the most pronounced changes we've seen over the last year. What changed, and why do you think we saw the changes occur so sharply?

Steve Singleton:
There were some very wide volatility swings we saw over periods as acute as intraday. The stage was set early in the year with the first of the four 75-basis point hikes. Single hikes of this magnitude had not been seen since November of '94 and serial back-to-back hikes of magnitudes like this take us back to 1980 in Volcker's move from 14 to 20% for the fed funds rate over the course of the year to defeat inflation. The 2022 backdrop of volatility was a similarity of purpose, which harkens back to that Volcker call, not necessarily in scope, but certainly in concept. (Paul Volcker, Former Chairman of the Federal Reserve, 1979-1987)

So as a reaction to economic news or suggestion that direction on monetary policy could shift, we would see two or more lightly correlated factors, volatility and momentum in particular, become negatively correlated and stage major moves in opposite directions where momentum was most aligned with the 2022 winning trade of value and profitability, and volatility aligned with the countertrend side of that, which was longer duration or no earnings, again, negative momentum, lower quality.

This latter set were the drivers, however, seen in several impressive rallies, consistent with the rallies we saw where volatility had been overdone in the short term or where investors assumed an announcement or indication of Fed pivot or pause was nearing. Stocks most positively correlated to these factors led and in doing so, have provided insight into what may lie ahead when we collectively see light at the end of this tunnel.

Matt Orton:
Yeah, that's great context, and it's the pivot party that hasn't really materialized yet. It's been crashed every single time. We probably know the answer, but I think it's worth asking anyway. How normal is it? Is it normal to see the dramatic whipsaws that we experienced throughout most of 2022?

Steve Singleton:
Factor movement is something you can expect. I mean, they shift in small increments over time and acutely during the day, but not nearly as dramatically on balance as we saw in 2022. That's partly because of what we saw with monetary policy, but also partly due to the fact that factor investing and factor consideration as we think of it today, separate from quantitative investing at large, which has been in force for 50 years, has really only been front-burner for the past decade.

You can harken it back to the post-Great Recession times where the combination of research affiliates in Willis Towers and Watson began exploring fundamental investing, which led us into the space of style betas and factor investing. That said, I think we'll see whipsaws at inflection points of regime change, perceived or actual, but perhaps not of the same magnitude, but still whipsaws all the same.

Matt Orton:
Thanks, Steve. I want to bring Pete back in, because one area that was pretty consistent over the last year was the outperformance of growth over value. Pete, maybe you can dive a bit deeper into what has really driven the outperformance of value. Are there certain sectors or industries or factors where this has been most noticeable and can this outperformance continue if and when we do see a true Fed pivot?

Pete Scholfield:
Yes. After a long drought, value outperformed growth in '22, and it was quite pronounced as a result of the Fed's rate-raising campaign. I think it has as much to do with why growth underperformed. To borrow from fixed-income parlance, longer-duration assets really took it on the chin. Growth stocks are just that. You're getting more of your return in the future relative to value stocks. Additionally, you had the challenge of starting point valuations for growth stocks being inordinately high at the beginning of the year, giving them more room to fall. Software was an industry that illustrates this. The higher growth, higher valuation stocks in this group were down 50% or more in '22.

As to sectors, the pattern was as you would expect, some of the classic growth sectors like tech and communication services were among the hardest hit, down 28 to 40% in the S&P 500. And the really extraordinary one on the value side was energy. Not only was this sector not down, it soared, up 66%. And while energy is not a large weight in the indices, that magnitude of a move certainly contributed to value trouncing growth.

The final part of your question on the eventual pivot, as Steve alluded to, with some light at the end of the tunnel, growth would most likely lead on the heels of that. We had evidence of that in '22 to support this. The three or four times where there was an expectation of a near-term Fed pivot, which of course, never came to pass, growth stocks jumped out in front of value for a short time.

Matt Orton:
I think what I took away as well just running some quick numbers, when you take the two underperforming sectors, the high-duration, like you said, versus what worked in energy, you're almost at 100% dispersion between the top and bottom performing sectors, which at least to me certainly seems a little bit mind-boggling and maybe highlights what you and Steve have been talking about with respect to some of the anomalies of 2022 and the differences we've seen.

A natural follow-up, I guess, then, Pete, is how do you manage around the potential change that we can see? What tangible actions should investors be thinking about to prepare for the eventual pause and rate hikes and ultimately maybe cuts coming down the road? Now, are there certain types of companies that you would want to own to prepare for this?

Pete Scholfield:
Matt, this is a tough one because we have two critical events that could happen in 2023. We don't know when, but the Fed will most likely wind down their rate increases. And as we've just discussed, this alone would suggest that investors might want to start moving some assets toward growth stocks. However, there's a big fly in the ointment, which is that we could now see a recession later in the year resulting from the Fed's actions.

Every additional move higher in fed funds rates takes recession probability higher, not to mention the depth and duration of the recession. To prepare for that, rather than emphasizing growth by itself in your portfolio positioning, I'd say that defensiveness and earnings certainty ought to be paramount in your stock selection. So you could focus on defensive growth. Some areas of healthcare exhibit those characteristics, for example.

Matt Orton:
Right. It seems like that ties to what Steve says about higher quality as well and that certainly makes sense. Let me ask you one other follow-up question because maybe this was anomalous during 2020 where growth was the defensive part of the market. Do you think that is typical of what we might see going forward, or do you think really it's being defensive within growth that that's going to be the way to go forward?

Pete Scholfield:
2020 had certainly a very unique circumstance with COVID unfolding throughout that period. Parts of tech for sure became defensive. People even called it a staples sector, part of the subgroup staples sectors, because of work from home and increased use of technology away from the office. I think that was an unusual time in 2020. Going forward and for 2023, I think it comes down a lot to what we're going to hear from companies. We've already seen in areas like semiconductors some downward revisions in forward estimates and guidance.

I'd also add that valuation, as I alluded to, is going to be critical. The starting point valuation going into last year was a challenge and a lot of that was corrected. I think a good part of technology now is fairly valued — if we don't get a lot of earnings resets.

Matt Orton:
Thank you, Pete. I want to take that same question now about managing around changing and flip it over to Steve and ask it from a factor perspective. How should investors think about identifying change in market character, whether it's durable, and how to lean into that change?

Steve Singleton:
From a factor perspective, absent noteworthy news or data that would signal a regime change like a Fed pivot or pause or economic or geopolitical news, we always advocate – and we do – watching the factors over a daily, weekly, monthly, and quarterly period and track the trending timeframes – i.e. what's in force, what isn't, and trying to discern why – looking for changes at the more acute ends to see if they are durable. It's what we do as part of our daily acumen. From a portfolio construction perspective, we're able to use mean variance optimization as a tool to access or lean into these durable changes often without the need to change names, just the weights, as alpha's usually found there at the margin.

Matt Orton:
Steve, I've got one follow-up on that just to make it a little bit more tangible. When I think post-October CPI (Consumer Price Index), momentum was absolutely crushed that day, but that wasn't a durable inflection point. How did you look at that big change? And similarly, we're starting to see momentum reverse a little bit at the start of this year in '23. How do you look at whether there's durability to that?

Steve Singleton:
Matt, we look for the breadth around these changes, and what we mean by breadth is just how many names are participating across factor categories, that is across size and across style? If we see a lot of movement across a broad sector of stocks in that fashion, that tends to be a signal that we're now going to actually really look closely for an ensuing follow-through in the next several days to weeks. Those are the pivots that we're looking for, the inflection points that we're looking for.

Sometimes, as we all know, they can end up being head fakes. You can get it for a day or two and then it flips back to the legacy trade. But in the case of what we tend to do is we strap in and look at a daily basis and watch the trending. Because overall, the trending actually tells us exactly where we want to be.

Matt Orton:
Great. Something that wasn't a head fake last year in 2022, that was really one of the most consistent outperformers was dividend yield and dividend growth. Pete, given your focus on a dividend value strategy, do you think this can continue in 2023?

Pete Scholfield:
The yield factor was indeed quite strong in '22 with a huge spread of relative performance between the highest-yielding stocks and non-yielders. In fact, one of the largest we've seen in all the years that we've tracked this. This was actually counter to the normal playbook of yield usually not doing well in a rising-rate environment. But in this case, with the short end of the yield curve moving up as far and as fast as it did, you wanted to define stocks that gave you a return of capital.

So there was no better place than dividend yield stocks for that. Whether it can continue, that comes back to our earlier discussion about the wild cards in '23: Fed pivot, recession risk, earnings guide downs, and so forth. I think that for as long as defense is winning over offense or risk-on, dividend yielders can continue to do well.

Matt Orton:
Great. I think this sets up nicely for a final question I'm going to post to both of you since we're running out of time, but I would love to hear from you, Steve and Pete, what you think is going to work going forward. Are there durable changes that you expect to see in 2023, and are there any sectors, industries, factors that look particularly attractive? Steve, I'll throw that over to you first.

Steve Singleton:
I'll speak from a factor and macro perspective and let Pete give his visibility into sectors and industries. Going forward, we see 2023 following the Fed in continued anticipatory fashion. While the prevailing debate still remains around the terminal fed funds rate target, what we know is that we're closer to the end of the hike cycle than we were 12 months ago. Thus, we start the year assuming that the 2022 trade still remains in force: that is, long value, quality, profit, and yield. But we see it with a shorter lifespan than we anticipated going into 2022, and that's largely because of the success we've seen in those factors over the last 12 months and that trade all together.

I left momentum out of that forecast because, consistent with nearing the end of the cycle trade, stocks that didn't participate as much in 2022 — they weren't necessarily long-duration — have been participating recently. These are not necessarily the current momentum stocks as we saw them last year. Some are lower quality as higher-leverage, less-predictable earnings trend, though an earnings trend all the same. This sort of extended all-boats trade anxiously awaits signs like we saw last Friday, like we've seen earlier this week, that the accumulation of the 2022 tightening cycle will show its broad effects not only on goods, but on services and even wages in coming reports.

In the face of this higher for longer stance that the Fed is staunch in at this point, this is still dovish and it sets up the other side of the trade where equity duration can and likely will be extended a bit and the growth names that were so uniformly beaten down in a mass repricing can see some respite, while similarly, those that were down with expectation of a slowing economy, recession perhaps, may not necessarily need to go any lower. Are we talking a floor? Perhaps we are, but we're awaiting the data to try to confirm that.

Matt Orton:
I've always got to ask about risks as well. Steve, is there a canary in the coal mine that we should be thinking about?

Steve Singleton:
Yeah. I would say a canary in the coal mine for the scenario just painted would be economic data that points to all the same causes and concerns that the Fed had going into '22, which would reverse the disinflation trend. That would be spikes in wage growth combined with continued upbeat job reports, stubborn CPI, PPI, and PCE (Consumer Price Index, Producers Price Index, and Personal Consumption Expenditures Price Index). That suggests that unlike past cycles, that there might be a new disconnect between monetary policy tools and their direct effect on recession and in part inflation.

Matt Orton:
Great. Pete, I'll toss it over to you for the final word.

Pete Scholfield:
Thanks, Matt. I think the financial sector looks attractive here with the possible exception of market-sensitive names; for at least the first part of the year I'd avoid them. Banks, in particular, should see some good net interest margin improvement from higher rates, but we do need to see credit stay benign for them to work. Another area would be the defensive growth parts of healthcare that we talked about earlier.

I don't think we'll see the one-dimensional year that '22 was. The key in '23 could be when we get to an inflection point, one where the focus on higher rates and recession risks shifts to a view of looking over the valley, you might say, to improvements in most of the areas that have held the market back. Maybe it won't be a complete shift from headwinds to tailwinds, but at least the wind in our face might subside.

Matt Orton:
Excellent. Thank you so much, Pete. Thank you, Steve, for joining. I think this was a really interesting and important conversation to have towards the start of the year. Thanks as always to our listeners for tuning in. And until next time, take care. Thanks for listening to Markets in Focus from Raymond James Investment Management. You can find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.