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Market Outlook: After a First-Quarter Decline, Equities Trading at a Slight Discount

Value and small-cap stocks are the most attractive.

Even before Russia invaded Ukraine, U.S. stocks were on a downward trend and interest rates had already started to rise. The attack added to the risk-off sentiment already permeating the U.S. markets. As of March 28, following the pullback so far this year, according to an intrinsic-value-weighted composite of our valuations, U.S. stocks are trading at a 2% discount to the broad market. The market has been extremely volatile this year as it contends with the four headwinds we identified earlier as well as the invasion of Ukraine by Russia. We suspect that volatility will remain high over the near term, especially until there is a resolution in the Ukraine conflict. Since the beginning of the year, our valuation has ranged from a 6% premium all the way down to an 11% discount.

Equity Market Is 2% Undervalued; Communications and Consumer Cyclical Sectors Have Highest Percentage of 4- and 5-Star Stocks

In our 2022 Outlook, we noted that the market was overvalued coming into the year and faced four main headwinds that the markets were going to have to contend with:

  • the slowing rate of U.S. economic growth.
  • tightening monetary policy.
  • rising interest rates.
  • inflation.

We continue to expect these to be the main drivers for markets over the rest of the year. While the conflict in Ukraine is certainly a humanitarian crisis, based on the research conducted by our analyst team we do not think it will have a significant, long-term impact on the U.S. markets. In our view, the four greatest risks from the Russia- Ukraine conflict are:

Potential Disruptions to Global Energy Production and Supply

Our view: Russia needs the currency, and Europe depends on Russian oil and natural gas. European sanctions exclude energy, as both Russia and Europe have vested interests to not disrupt it.

Inflation Stays Higher for Longer

Our view: We ratcheted up our U.S. inflation forecast at the beginning of March. However, we are still of the opinion that because much of the inflation the U.S. has experienced is due to factors that we think are temporary, it will begin to moderate in the second half of the year.

Additional Supply Chain Disruptions

Our view: Very limited supply chain issues so far. The greatest risk is that Ukraine reportedly supplies half of the global supply of neon gas, which is used in lasers that etch silicon for semiconductor chips. Manufacturers have several months of supplies, which we expect will be enough time to source from other suppliers.

Financial Contagion

Our view: Russia and/or Russian and Ukrainian corporations may default on their debt. Current foreign holdings of Russian debt are not globally significant, and exposures are a relatively small percentage of European bank capital levels.

Across U.S. stocks, value stocks remain 5% undervalued. In our 2022 Outlook we noted that value stocks were attractive on a relative basis compared with core and growth stocks, which were both overvalued at that time.

Value Stocks Are the Most Attractive, but Growth Is Close Behind

Year to date, the Morningstar US Value Index has risen 3.25%, whereas the Morningstar US Core Index has declined 4.72% and the Morningstar US Growth Index has dropped 11.02%. Following the downturn in growth stocks, the category now trades at the low end of our fair value range, and mid-cap and small-cap growth stocks are undervalued.

Wide-Moat Stocks Are Attractive

Core stocks have fallen to fair value range. Across the capitalization levels, large-cap and mid-cap stocks are close to fair value, but small-cap stocks are undervalued across the board.

We Cover Fewer Small-Cap Stocks, but They Offer the Highest Percentage of Value

Undervaluation Is More Spread Out Across Categories

Communications Sector the Most Undervalued by Far

As the pandemic continues to recede in the U.S., we expect consumer behavior will normalize toward prepandemic activity and that spending will shift back toward services and away from goods. During the pandemic there had been a significant shift in spending habits, as activities like travel and entertainment were under extreme duress and consumers were either unable or unwilling to venture into public venues. Our U.S. economist, Preston Caldwell, thinks that spending on services could return to trend within a year.

As the Pandemic Recedes, Expect Consumers to Shift Spending to Services

We had ranked the energy sector as the most undervalued for the past two years, but after a 55% return in 2021 and an almost 39% return this year, it is now fully valued, and in some cases, overvalued. We think that now would be a good time to move from an overweight position to a market-weight position and lock in some of the gains over the past 15 months. The spot price of oil and natural gas both already include a large "war premium" in their prices, and the direction of that premium can swing both up or down depending on how and when the conflict in Ukraine is resolved.

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