Despite looming recession risks, regional bank challenges, and the Federal Reserve continuing to tighten with no signs of easing on the horizon, the S&P 500 rallied over 20 percent from its October 2022 low and closed its longest bear market since 1948. Though the stock market rally has been exceptionally narrow and led by artificial intelligence (AI) fever, the S&P 500 has returned almost 17 percent in the first half of 2023 with the NASDAQ returning over 32 percent! Treasury yields have rebounded from their March lows as U.S. economic data, particularly over the last few weeks, has surprised to the upside and a resolution was reached in the recent debt ceiling debate.
The Fed’s 25 basis point hike in May was thought by many to be the last interest rate increase of the current cycle, but resilient economic data, strong market performance, and Fed commentary suggest that we could see another one or two interest rate hikes this year. Inflation continues to slow but remains persistent and is not decelerating quickly enough to prompt any meaningful change to the Fed’s current stance.
Corporate earnings declined in the first quarter, albeit to a less-than-feared extent than what was expected at the start of the earnings season. Throughout the first half of 2023, sentiment has waxed and waned regarding the outlook for inflation, recession, corporate profits, geopolitics, and especially a Fed pivot back to more accommodative policy, but at this juncture, sentiment appears to have shifted more toward the camp of optimism or “soft landing” compared to a more cautious tone that prevailed following the failures of Silicon Valley Bank and Signature Bank at the end of the first quarter. As we look to the second half of the year, we expect to see a further push-pull between caution and optimism as we digest more economic data, corporate earnings reports, and Fed guidance.
Source: Bloomberg as of June 30, 2023. Past performance is not indicative of future returns. Indices are unmanaged. You cannot invest directly in an index.1
AI elation drives equity bull market
2023 equity market performance is shaping up to look quite different from 2022 thanks to Chat Generative Pre-Trained Transformer or ChatGPT, an AI chatbot that became the fastest-growing consumer software application in history. According to the McKinsey Global Institute, generative AI is set to add up to $4.4 trillion of value to the global economy annually, and half of all work will be automated between 2030 and 2060. Many investors are betting that AI will boost productivity and profit margins, and based on this year’s price action, are already predicting which companies will benefit most from the AI revolution. Take NVIDIA, which is the posterchild for the AI frenzy, and has returned approximately 190 percent in the first half of 2023.
Source: Bloomberg as of June 30, 2023. Past performance is not indicative of future returns.
As a result of AI excitement, this year’s U.S. stock market rally has been exceptionally “narrow” and driven by a small group of technology companies. Just eight stocks (Facebook/Meta, Apple, Amazon, Netflix, Alphabet, Microsoft, NVIDIA, and Tesla) have contributed approximately 80 percent of the S&P 500's return in the first half of the year. We have written before about the dominance of technology companies in the U.S. stock market, and the trend has only intensified. According to Goldman Sachs, Apple and Microsoft now comprise a larger share of the S&P 500 (14 percent) than any two companies have since 1979.
Will AI change the global economy in the same way as the internet or the iPhone? Perhaps, but it might take several years, and we are still in the early innings of discovering which industries and companies will benefit most. New technology is exciting, and investors do not want to miss out on the next Apple or Amazon. However, amid all the excitement and exponential growth in stock prices, we continue to stress the importance of diversification, fundamentals, and a long-term view when investing.
Source: Bloomberg as of June 30, 2023. Reindexed values such that Jan. 1, 2018, = 1. Past performance is not indicative of future returns. Indices are unmanaged. You cannot invest directly in an index.
U.S. economic resilience prevails in the second quarter
For more than a year now, recession fears have gripped economists and market participants alike. The consensus still calls for a 65 percent probability of the U.S. economy entering recession within the next twelve months. The economy is not exactly firing on all cylinders, but a tight labor market continues to support consumer spending, which accounts for around two-thirds of the U.S. economy. Unemployment sits at a historically low 3.6 percent, and monthly job growth is a far cry from recession. First quarter GDP was recently revised up to 2.0 percent from 1.3 percent, driven by consumer spending.
Despite recent data indicating a relatively resilient economy, many economists remain cautious. Some still see a chance of recession beginning as soon as this year while some believe that the timeline has simply been pushed back. The jobs market, while strong, is no longer “red hot” with job openings down about two million from their 2022 peak and wage growth decelerating.
Excess pandemic savings are dwindling (and are depleted in the case of lower and many middle-income households), and according to Federal Reserve data, U.S. household debt now sits at $17.05 trillion, increasing by $2.9 trillion since the end of 2019, just before the pandemic. The resumption of student loan payments could be a headwind to growth, affecting around 40 million people, and totaling $1.75 trillion across federal and private loans. With an average student loan payment of around $380 per month, that is an approximate $15 billion per month headwind to consumer spending.
Source: Strategas Macro as of June 30, 2023.
At the beginning of this year, bond markets priced in a peak Fed funds rate of around 5 percent and around two, 25-basis point cuts in the second half of the year. Now, the market expects another 25-basis point increase in July, resulting in a target Fed funds rate of 5.25 percent-5.50 percent, and interest rate cuts are no longer expected in 2023. In fact, the Fed expects to hike two more times this year and does not expect to cut interest rates until 2024.
The Fed is unequivocally more concerned about getting inflation down to its target than it is about the risks of recession. Although inflation has more than halved from a year ago when it was 9 percent, it is still 4 percent year-over-year, which is well above the Fed’s 2 percent target. Inflation is certainly moving in the right direction, and excluding certain measures like rent, it is not far off from the Fed’s target. CPI excluding owner’s equivalent rent has risen 2.6 percent year-over-year.
With higher-for-longer a prevailing market theme, interest rates have rebounded from their spring lows, particularly shorter-dated Treasury yields. As a result, at the end of the second quarter, the yield on the 2-Year U.S. Treasury was 106 basis points higher than that of the 10-Year U.S. Treasury (commonly referred to as the 2s10s curve), near the most extreme level of inversion seen this year, last observed before the failure of Silicon Valley Bank. The yield curve has now been inverted for more than a year.
Source: Bloomberg as of June 30, 2023.
As we have written before, bond yields remain attractive. Furthermore, the competition for capital remains high and ultimately makes the proposition for taking equity risk less compelling. For example, U.S. and European high yield bonds currently offer average yields in the 8 percent to 9 percent range, roughly twice the level available at the end of 2021. There are currently no S&P 500 sectors that have a larger dividend yield than the 2-year Treasury bond.
Source: Bloomberg as of June 30, 2023. Past performance is not indicative of future results.
Looking ahead
Looking to the second half of 2023, we are wrestling with the same debates we had at the start of the year:
- What is the timing of recession?
- How severe will the recession be?
- How far will the Fed go with interest rate hikes?, and so forth.
We have seen some historically unique dynamics in the first half of the year, including a handful of companies driving market returns due to the emergence of AI. Concerns over the banking system faded following some of the largest banking failures in history, and despite the Fed continuing to tighten, the economy continues to outperform expectations.
There are also few signs of stress in the current backdrop. Credit spreads, a measure of risk or stress in the market, are below long-term historical averages, and both investment grade and high yield bond spreads have retreated to early March levels, before the failure of Silicon Valley Bank. Credit defaults and consumer delinquencies are rising, but from historically low levels.
As we round out six months of very strong market performance, we remain focused on risks and opportunities on the horizon. Economic growth has been stronger-than-anticipated, but the trend remains one of slowing growth and fading tailwinds. AI and associated productivity gains are certainly reasons to be optimistic, but how quickly the economy can reap the benefits of these gains is uncertain. We asked ChatGPT how we should invest based on the current environment and got the following response “remember, investing involves risks, and past performance is not indicative of future results. It’s crucial to do thorough research, seek professional advice, and make informed decisions based on your unique circumstances”. Well said, ChatGPT.
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