Investment Overview: 2nd Quarter 2023

The economy

Equity markets responded favorably to a stronger-than-expected economy in the second quarter of 2023. Fed rate hikes that have been ongoing for more than a year now have not yet resulted in a recession that many prognosticators predicted, with the economy even weathering a first quarter banking scare which saw the second largest bank failure in U.S. history. Rising new home sales, orders for durable goods, and consumer confidence suggest enduring economic growth. The Fed Funds Rate now stands at a range between 5% and 5.25%, the highest level in 16 years. U.S. GDP grew at an upwardly revised 2% annual rate in the first quarter, with similar estimates coming in for the second quarter.

Consumer spending grew at a 4.2% annual rate in the first quarter, the fastest pace since the middle of 2021 as employers continue their aggressive hiring. The most recent initial jobless claims report came in lower than expected, evidence that a tight labor market persists. In May, employers added 339,000 jobs, bringing the total number of jobs added this year to nearly 1.6 million, a gain of 2.5% annualized. Surprisingly, job gains have been for the most part widely distributed across the economy as even industries directly affected by rising interest rates have continued to add workers.

While consumer spending remains robust, the Fed’s rate increases have certainly reduced economic activity in the manufacturing sector. Manufacturing PMI came in at 46 in June, following a reading of 47 in May. The index has had eight straight readings below 50, indicating the U.S. is indeed in a manufacturing recession. Manufacturing businesses tend to have higher levels of debt compared to their consumer services counterparts, and increasing interest rates coupled with a post-pandemic shift in consumption from goods to services has had a disproportionately negative impact.

Despite significant headway, inflationary risks persist. The consumer-price index rose 4.0% in May from a year earlier, well below the recent peak of 9.1% last June and down from April’s 4.9% increase. The slowdown in inflation can be mostly attributed to falling energy prices and improving supply-chain bottlenecks. Oil has fallen by nearly half in the past year, from around $120 to less than $70. While inflation is getting closer to the Fed’s goal, falling labor productivity may present a challenge and require higher interest rates for longer to finally tame inflation. Labor productivity has fallen for five consecutive quarters, the longest such stretch since records began in 1948. When asked when inflation will return to the 2% target, Federal Reserve Chairman Jerome Powell indicated that inflation has moderated, but also stated that “inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go.”

Internationally, geopolitical tensions remain a pressing concern as the Russian/Ukrainian War rages on with little if any resolution in sight. The human toll has been tragic. Mercifully though, the economic fallout from strained food and energy production and exports has been less severe than feared. On the emerging markets front, evidence of faltering Chinese growth continues build, with its manufacturing sector contracting for a third straight month in June. Manufacturers appear to be repositioning their operations to diversify supply chains, a trend that does not bode well for China’s role as the world’s factory floor.

Fixed income

The Federal Reserve’s response to surging inflation began over one year ago and has resulted in its benchmark Federal Funds rate being hiked 500 basis points to date over this time period. In fact, rates are back to their previous high levels seen just prior to the start of the Great Financial Crisis of 2008.

During the quarter, the Fed raised rates at its May meeting to a level of 5.00%-5.25%, but skipped a rate hike at its June meeting, which halted a series of 10 consecutive increases stretching back to its meeting last March. The “skip” in June may not have been as dovish as it seemed on the surface, however, as a clear signal was communicated that more hikes may be needed for the balance of the year. 

Progress has been made in fighting inflation, with headline CPI inflation falling to 4.0% in May, representing the smallest year-over-year rise in over two years. However, the Fed’s preferred inflation gauge, the core PCE index, registered a 4.6% increase over the past year. This metric is showing that the “stickier” components of inflation remain well above the Fed’s targeted level of 2%. The Fed does expect further progress with core PCE inflation this year, but it still will likely not achieve its targeted levels.

The 3-month Treasury, often seen as a proxy for money market funds, saw its yield rise alongside the Fed Funds rate. Longer dated bond yields rose to a lesser extent, as the likelihood of “higher for longer” rates became more embedded in market expectations. This backdrop has led the yield curve to move to an even more inverted state than where it began the quarter. This dynamic is often an indicator of a pending recessionary period. The Federal Reserve is in a precarious position as it must balance the risks of elevated inflation versus the economic damage that can occur from overly restrictive monetary policy.

With the rising rates of the past quarter, bond returns were slightly negative, as falling bond prices offset the interest received on most bonds. The lone bright spot were high-yield bonds, as the market is not yet concerned about possible credit issues which may accompany economic stress.

The Federal Reserve’s next Open Market will be held in late July, where the prevailing sentiment is that the Fed will resume tightening with another 25-basis-point hike. While the Fed may be nearing the end of its hiking cycle, it appears we are not yet close to any pivot toward cutting rates.

Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).

Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).

Equities

The widely followed S&P 500 rose nearly 9% during the second quarter, its third straight positive quarter and its biggest quarterly gain since the final period of 2021. Meanwhile, the technology-heavy Nasdaq Composite Index gained 13% for the quarter and enjoyed its best first half of a calendar year since 1983. Apple Inc. (AAPL) remains the largest stock in the U.S. and reached an astounding $3 trillion market cap at the end of the quarter, just five years after becoming the first U.S. company to hit the $1 trillion value.

One of the primary factors driving the market was enthusiasm over the potential for artificial intelligence (AI). Companies leveraged to AI generally vastly outperformed during the quarter, despite lofty valuations and inherent uncertainties regarding the new technology. Markets also benefited from the belief that the Fed is nearing the end of its tightening cycle, which, all else being equal, may provide a tailwind going forward.

One potential cause for concern is that the 2023 rally has seen some of the narrowest breadth in history, meaning just a handful of stocks are driving the majority of the market’s gains. The equal-weighted S&P 500 and the Dow Jones Industrial Average both returned far less than the S&P 500, which is market-cap weighted. Also, small- and mid-cap indices trailed the S&P 500 on a relative basis as well. 

Outside the U.S., developed market international equities continued to perform well and have largely matched domestic returns over the past 12 months, although they did trail their domestic counterparts for the quarter. Emerging market stocks eked out a positive gain but have lagged other major indices by a wide margin over trailing time periods.

Despite the rally in markets, corporate earnings per share have actually declined year over year. However, many companies did post better-than-expected results, which provided positive reactions in many cases. Historically, aggregate earnings are closely associated with market prices and returns over time.

Overall, stock market valuations are now more reasonable than they were prior to the 2022 downturn; however, investors will need to closely monitor how earnings growth materializes against an uncertain economic environment. As of quarter-end, the S&P 500 is trading at a price-to-earnings ratio of over 19x, which is above its historical average. Ultimately, the ability of corporations to maintain profit margins or achieve revenue growth with a difficult backdrop may provide clues as to the direction of the broad market for the balance of the year.

Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).

Sector returns

For the second consecutive quarter, returns in sectors dominated by mega-cap technology-related stocks more than doubled the returns of any other sector in the market. Technology, Discretionary, and Communication Services again posted strong double-digit returns as the momentum from the first quarter continued amid a strong preference for the potential of faster-growing companies.

While all other sectors trailed the market’s return on a relative basis for the quarter, most still posted positive returns on an absolute basis. It was notable that the Financials sector regained some ground after a poor first quarter marked by high-profile bank failures and general unease on the health of the entire sector.  

Energy stocks posted another modest loss during the quarter after leading the market during 2022, as oil prices fell in back-to-back quarters for the first time in over three years. Utility stocks were at the bottom of the ledger, as a combination of higher interest rates and investor preference for faster growing companies weighed against the sector.

Despite the continued uncertainty regarding the economy, investors have shied away from traditionally defensive areas of the market like Consumer Staples, Utilities, and Health Care. If an economic slowdown were to materialize, the leadership of the market might be expected reverse in the second half of 2023.

The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).