2nd Quarter 2023: Mid-Year Review and Outlook

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Market Analysis

Summary:

  • The US stock market displayed robust growth in the second quarter, with the S&P 500 index gaining 8.3% and the NASDAQ 100 advancing by 15.16%. Developed international and emerging market stocks were mostly flat during the quarter.
  • Bond performance was mostly flat during the quarter, but investment grade corporate and high yield bonds are up for the first half.
  • The US economy added 732,000 jobs in Q2, but job growth decelerated slightly compared to Q1, and the unemployment rate rose marginally to 3.6%.
  • Inflation saw a surprise decrease, dropping to 2.97% in June, well below expectations. The unexpected drop in inflation raised hopes that the Federal Reserve could achieve its 2% inflation target without a recession.
  • The strong stock market performance was concentrated in a handful of stocks and driven by decreased inflation, greater clarity on interest rates, and the building buzz around artificial intelligence (AI) which is seen as transformative for numerous industries.
  • We reduced our recession probability forecast to less than 50% over the next 12 months due to the resilience of the economy and lower than expected inflation. However, we are cautious due to high equity valuations and moderating economic growth, with fixed income markets offering attractive buying opportunities.
  • Diversification is crucial in this environment; investors are best served by maintaining discipline and staying the course.

Market Analysis

The second quarter added more steam to the first quarter’s rally, with US stocks posting robust growth. The S&P 500 index of large cap stocks advanced by 8.3% to close the first half of 2023 up by almost 16%, while the NASDAQ 100 index of technology companies added 15.16% for a stellar first-half performance of 38.75%. This was a significant comeback for the NASDAQ considering it declined by more than 30% in 2022. 

 

Developed international and emerging markets stocks were largely flat during the quarter as the US Dollar showed some signs of stabilization. 

 

On the fixed income front, investment grade (IG) corporate bonds[i] fell by 38 basis points (0.38%) on a total return basis but ended the first half up 4.26%. High yield corporate bonds[ii] increased by 78 basis points to close the first half up 4.48%.

 

Job growth decelerated during the quarter, but labor markets continued to show strength. The US economy added 732,000 jobs in the second quarter and the unemployment rate ticked marginally higher to 3.6%. The four-week moving average of initial claims for unemployment insurance increased modestly to 257,000 at the end of June, before declining in July. 

 

Inflation was the big surprise during the quarter. The June Consumer Price Index (CPI) dropped to 2.97%, well below expectations, from 4.05% in May. Just last July the CPI peaked at 9.06%. Core Personal Consumption Expenditures (PCE), the Fed’s preferred measure of inflation which strips out food and energy prices, dropped to 4.1% in June from 4.6% in May. The sharper than expected drop in inflation fueled hope that the Fed may be able to achieve its 2% inflation goal without a recession. 

 

The Fed raised interest rates twice during the quarter, with its 25-basis point increase in July being viewed as the last hike in the cycle by many investors.

 

In our first quarter newsletter, titled “Preparing for a Range of Outcomes,” we assigned the probability of a recession in the second half of the year at greater than 50%. In our base case view, we anticipated that:
  • Inflation would be stickier than expected, leading the Fed to either rase rates higher than expected or hold rates steady for longer than expected.

 

  • Labor markets would begin to deteriorate as layoffs continued to mount and eventually lead to a slowdown in consumer spending.



  • The fallout from the Silicon Valley Bank collapse would result in tighter lending standards among small and medium-sized banks, making it more difficult for businesses to obtain financing.

We also highlighted the positives that we saw in the economy, which we believed underscored the need for investors to prepare for a better-than-expected market scenario and not put all their eggs in the recession basket, even though our base case view called for one. Particularly, through the first quarter, labor markets and consumer spending were much stronger than we would have expected. That led us to believe that the momentum could carry forward into the second quarter.

 

Additionally, we acknowledged that the interest rate environment was looking more favorable going forward. We believed we were close to the terminal rate, and even though the Fed was likely to hold rates steady for an extended period, the market would view a pause positively.

 

So why did the market perform so well in the second quarter despite our recession call? It boils down to two things: inflation and artificial intelligence (AI). 

 

The surprise drop in inflation during the second quarter renewed hope for a soft landing, where the Fed gently slows economic growth to achieve its inflation targets without causing a recession. We now have greater clarity on the interest rate environment. Additional rate hikes, while not completely off the table, appear to be very unlikely from this point on. 

 

The strong stock market performance this year has not only been fueled by falling inflation and interest rate clarity. According to Bloomberg, references to “AI” are up drastically on technology company earnings calls in 2023 compared to in 2022, while recession references are down[iii].

 

Investors have been buzzing since the introduction of large language models and generative AI used by platforms like OpenAI’s Chat GPT and Adobe Photoshop. AI is viewed as a transformative technological development that will have far-ranging impacts across all industries, changing the way companies conduct business and customers consume goods and services. While it is too early to say whether we are in an “AI Bubble,” we do believe that AI will have far reaching impacts across industries as it develops. Transitional shifts and long-term trends often start with a buzz before sorting out the substance later. 

Outlook 

As new economic data comes in, we are constantly reevaluating our forecasts. Given the economy’s resilience and lower-than-expected inflation, we now see the chance of a recession as less than 50% over the next 12 months. History suggests that interest rate tightening cycles are almost always followed by rising unemployment and recession.  We still believe this is true, but we just have not yet seen concrete signs that a recession is imminent. One of the most dangerous idioms in investing is “this time is different,” but it would be foolish of us to ignore the data as we see it. As always, we continue to evaluate new data as it is available and adjust our forecasts as necessary.

 

Looking forward, it is important to recognize that the stock rally this year has been fueled almost entirely by multiple expansion, not earnings growth.  The forward price-to-earnings (PE) ratio of the S&P 500 increased from 17.8 times at the end of March to 19.1 times at the end of June. The 25-year average multiple is 16.8 times. 

The rally has also been highly concentrated in a handful of mega-cap companies[iv]. 

 

The top ten stocks in the S&P 500 account for almost 32% of the total market cap of the index. Yes, that means more than 30% of the value of the 500 largest companies in the United States is concentrated in only 10 stocks!  The PE ratio of the top ten is 29.3 times compared with only 17.8 times for the rest of the index. The chart below shows the dispersion between the market-cap weighted SPDR® S&P 500 ETF (SPY) and the Invesco S&P 500® Equal Weight ETF (RSP) in the first half of 2023.

 

If more investors begin to believe in the soft-landing, then we think the market rally should broaden out, leading to a catch-up rally among the stocks and sectors that have not yet fully participated. The valuations of those companies are much more reasonable and suggest that they may have more upside potential compared to the names that have already rallied significantly and are expensive relative to historical valuation measures. 

 

It is important to remember that valuations alone do not have significant short-term predictive power, but over longer time periods high valuations tend to be correlated with lower average returns, while lower valuations are correlated with higher average returns[v].

 

We think it is appropriate to be optimistic about the economy and the prospect of a soft landing, but believe that investors should be cautious, especially when it comes to stocks. Especially in the more richly valued companies, any slip in earnings performance or expectations could hit those companies the hardest. We also see economic growth continuing to moderate, and while it may not contract in a soft-landing scenario, a very low growth and lower inflation environment would make it difficult for companies to grow earnings.  

 

Just like in the first quarter we see great value in the bond market, especially as we have much more clarity on the interest rate environment:  
  • We do not expect the Fed to raise interest rates again from here. We think there is less than a 25% chance of another 25-basis point interest rate hike before the end of the year. 

 

  • We expect that the Fed will hold rates steady through the end of the year and into the first quarter of 2024 before it may begin to cut rates.



  • A steady rate environment is positive for bond investors as sale proceeds can be reinvested at current high yields, and the likelihood of a rate increase, which would decrease bond prices, is low.

 

  • A falling rate environment, like the one we expect next year, would be a positive for bond prices, as bonds with today’s high yields would increase in value as rates drop.

 

  • Yields are at or near the upper end of their 10-year ranges across nearly all fixed income categories, representing attractive buying opportunities.

Overall, we see great relative value in much of the fixed income market relative to equities, which have much greater uncertainty and higher expected volatility. The high yields offered in bond investments today mean that investors do not need to increase risk in their portfolios to generate returns. 

 

Even though the prospect of a soft landing is more likely, this environment is not suitable for tilting portfolios too aggressively or defensively. Investors should take a balanced approach, allowing their portfolios to participate in market upside without taking on excessive downside risk. 

 

We still think a recession and more equity volatility could come. While the economy has proved to be resilient, and the stock market has rallied strongly on optimism of lower inflation and new technologies, the data can change quickly.  It may yet take some time for the Fed’s interest rate hikes to have an impact on the economy; if July marked the final rate hike it could take until well into 2024 before that impact is felt. 

 

Equity valuations are high considering the current interest rate environment and it may be difficult for the most highly valued companies to live up to investor expectations going forward. We see economic growth moderating over the next year, not expanding, which will make it difficult for companies to increase earnings.

 

As we move forward through the remainder of 2023, we do so with a cautious optimism for the economy and equity markets, while attempting to capitalize on the relative value we see in fixed income markets. 

 

We pride ourselves on collaborating with clients to develop thoughtful investment plans to help them reach their goals. As we continue through this year, we believe investors are best served by maintaining discipline and focusing on the long-term view. We will continue to evaluate opportunities to reallocate portfolios as the investment environment evolves, and in taxable accounts we actively look to take advantage of volatility and add value by tax-loss harvesting. 

Sources: 

[i] As measured by the iShares iBoxx $ Investment Grade Corporate Bond ETF (symbol LQD)

[ii] As measured by the iShares iBoxx $ High Yield Corporate Bond ETF (symbol HYG)

[iii] Bloomberg, “AI Mentions on the Rise as Recession Talk Fades” https://www.bloomberg.com/news/articles/2023-07-28/ai-mentions-on-the-rise-as-recession-talk-fades-tech-watch?in_source=embedded-checkout-banner

[iv] JPMorgan. Guide to the Markets, Slide 11. https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets/

[v] JPMorgan. Guide to the Markets, Slide 6. https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets/

Important Information  

Advisors Financial, Inc. (“AFI”) is a registered investment advisor.  Advisory services are only offered to clients or prospective clients where AFI and its representatives are properly licensed or exempt from licensure. 

The information provided is for educational and informational purposes only and does not constitute investment advise and it should not be relied on as such.  It should not be considered a solicitation to buy or an offer to sell a security.  It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon.  You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions.  These documents may contain certain statements that may be deemed forward looking statements.  Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.  Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

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