2023 | 2nd Quarter
At the close of last quarter, we were concerned about the banking system and its exposure to higher interest rates. While those fears have subsided concerns remain about banks portfolios of low yielding bonds and exposure to commercial real estate. The second quarter began with apprehension over the debt crisis, and whether government payments and debt service would be made on time. Markets were choppy leading up to the passage of the Consolidated Appropriations Act 2023 on May 17, 2023, but we officially exited the bear-market on June 8, after climbing 20% from the October 2022 low.
Market indicators recap: For the quarter the S&P 500 returned 8.7% and is up almost 17% for the year. However much of the return was concentrated in a very few sectors and technology in particular. For the quarter, the technology heavy NASDAQ returned 13% and is up over 32% for the year. Small and Mid-cap stocks as well international shares all underperformed the large cap indices as returns in large growth stocks outpaced all other sectors of the market. Interest rates rose with the yield on the 10-year US Treasury note at 3.42% at the beginning of the quarter and rising to 3.82%.
Value and dividend-paying stocks (such as banks) underperformed, giving way to the ally in growth stocks, heavily weighted toward technology and health care. We highlight several large companies showing impressive year-to-date performance. Facebook (META), up 139%; Nvidia (NVDA), up 191%; Tesla (TSLA), up 113%; GE, up 68%; Apple (AAPL), up 49%; Microsoft (MSFT) up 42%.
The move higher in the stock market was driven, once again, by a small group of mega-cap tech names. These stocks have dominated market moves, on both the upside and downside, because they represent such a high percentage of the widely followed market indices. At quarter-end Apple and Microsoft were the two largest stocks on the S&P 500 index, representing more than 14% of the index capitalization. That is a larger share than any two companies have had since 1979. They were both up every month this year and are at, or near, their all-time highs. Moreover, the top seven stocks in the S&P 500 are all tech names, with each registering double or triple digit returns for the first half of the year. Those stocks represent about 30% of the index value but generated more than 70% of the index return since year-end. The high concentration of these tech names, and their out-sized returns and high valuations, raise concerns that the stock market has become over-concentrated, increasing the risk that disappointing news from any one of these companies could spark a sudden market pullback.
S&P 500 earnings expectations have declined, hampered by higher interest rates, which puts pressure on equity returns and somewhat explains the outperformance of growth stocks with strong earnings outlooks. However, as we discuss below, a pause in interest rate hikes and a gradual lowering of rates in 2024 could improve the outlook. The flip side of higher rates is that fixed income is benefiting from capital flows.
This Market Commentary focuses on three themes: Fed policy; the inflation forecast; and the likelihood (and timing) of a recession.
Fed policy – The federal funds rate in April was 5.10% and rose to 5.25% in May. The market had been pricing in one to three hikes in 2023, (which we never believed) based on a rise in unemployment claims and a disappointing GDP report. The Fed announced a pause at its June FOMC meeting on the heels of the Consumer Price Index (CPI) rising a mere one-tenth of a percent in May, though Chair Powell indicated it was a “brief respite,” rather than an end to rate hikes, as inflation “remains well above” the 2% target rate. He added a prediction for inflation to be 3.9% at year end.
Inflation forecast – We began the quarter with inflation expectations, measured by the Personal Consumption Expenditure (PCE) index, at 3.3%, up from 3.1% previously. In addition, The University of Michigan’s mid-April Consumer Sentiment reading showed consumers’ expectations for inflation rising 4.6% by April 2024, consistent with the PCE price index’s 4.2% annualized pace. The May reading showed expectations still at 3.3%, with PCE prices moderating slightly.
Clearly, consumers still see tough times ahead. All quibbling aside over a few points in either direction, inflation (though declining somewhat) likely is here to stay as we attempt to bring manufacturing stateside, decouple from China, and resolve international conflicts.
Recession outlook (and timing) – Employment is a key ingredient governing the will we/won’t we recession equation, and employment has remained strong despite lackluster growth.
Manufacturing data also points to a slowdown: The Institute for Supply Management Index (ISMI) posted a 46.9 reading, its seventh consecutive monthly decrease (a reading below 50 represents contraction).
One of the more closely watched metrics is the Conference Board’s Leading Economic Indicators (LEI), in negative territory for 14 consecutive months (having peaked in February 2022), and now at its lowest point since November 2020. When it falls more than 4% over a six-month period, it signifies a recession.
A final point on the pro-recession case is the widely touted inverted yield curve, with short-term rates outpacing long-term yields. (This has been so for a while – and we haven’t yet seen a recession.)
New home sales have risen for the past three months and now are at their highest level since February 2022 and up 20% year over year. Personal spending is up, consistent with steady retail sales in April and May.
Finally, the fears pointing to a recession at the beginning of the quarter (soft labor market, the banking crisis, debt ceiling concerns, rising fuel prices) appear to have subsided. And consumer confidence spiraling to 109.7 in June may be the icing on the cake, or at least a signal that a recession, now forecast for 2024 (because of sticky inflation prompting a few more interest rate hikes), may be couched as a soft landing.
What it all means – Hopefully the strength in the market points to further increases, as second-half market gains tend to correlate with first half advances. The Fed isn’t finished hiking rates, so be prepared for one or two more hits this year before tapering in 2024 as it continues to fight stubborn (but slowing) inflation. A recession is likely at some point, but probably not until Q12024, and may be relatively mild if it does occur.
As always, feel free to contact us with questions.
Jonathan F. Kolle, CFA®
President, Chief Investment Officer
Daniel A. Morris, M.S.
Co-Chief Investment Officer
Joseph K. Champness
Director
Shawn R. Keane, CFP®
Vice-President
Cindy de Sainte Maresville, CFP®
Certified Financial Planner
Rusty Giles
Director of Marketing
James V. Kelly, CFA®
Director
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