Most investment categories posted gains in the April-June period, adding to the rally that began last October. Large-company domestic stock benchmarks posted three-month gains anywhere between 3% (Dow Jones Industrials) and 13% (Nasdaq Composite); U.S. small-company stocks rose around 4%, on average. Among non-U.S. stocks, developed-market benchmarks were up approximately 3%, while the emerging-market category gained around 1%, on average. Domestic real-estate-related securities gained in the low-single digits; non-US issues fell by a similar amount. Commodity prices were lower: gold was off a bit less than 3%, oil fell 7% and copper dipped 8%. Bond yields ended higher (the 10-year Treasury finished June at 3.82%, compared with 3.49% on March 31st) while credit spreads mostly narrowed, resulting in fixed-income returns ranging from modestly negative to modestly positive, depending on maturity and credit exposure.
Among large-capitalization U.S. stocks, those in the Communication Services, Industrials and Technology groups recorded the strongest gains; those in the Basic Materials, Consumer Staples, Energy and Health Care sectors lagged. The “growth” investment factor clearly dominated “value” for a second consecutive period among both large- and small-company stocks.
As the spring regional-bank mini-crisis receded from the headlines and evidence of economic resilience and ebbing inflation continued to accumulate, major stock benchmarks made steady progress from April through June. Meanwhile, intermediate- and longer-term bond yields drifted higher, though they remained below the peaks seen in late 2022.
The U.S. economy exhibited surprising strength in the face of aggressive Federal Reserve monetary tightening. Aggregate activity (GDP) in the January-March period notched a respectable gain of +2.0% (annualized). Though the headline figure was below the +2.6% recorded in the final three months of 2022, underlying consumption grew a robust +4.2% (offset by weak investment in housing and inventories). Monthly job additions averaged more than 237,000 in the four months through June; unemployment hovered near a multi-decade low, ending at 3.6%. Easing inflation (including falling gasoline prices), rising stock markets and the federal government’s (temporary) resolution of the debt-ceiling stand-off buoyed consumer confidence – albeit from a depressed level. And a stabilization of the residential real-estate market was confirmed: home-builder sentiment continued to rise steadily, while existing house prices ended their seven-month decline, gaining ground in each of three monthly reports. Worriers could nevertheless point to weak purchasing-managers surveys (the manufacturing sector has been contracting for seven-consecutive months; the larger service sector was still expanding, but the May reading was the weakest since December 2022), a distinct upturn in unemployment claims, and an accelerating decline in the index of leading economic indicators.
Economic growth overseas was mixed. Recording first-quarter GDP of minus-0.4%, the euro-zone economy contracted for a second-consecutive period, meeting a common definition of recession. Following a global pattern, weakness was concentrated in manufacturing and most acute in Germany, where the economy shrank -1.3%; conversely, Spain, Italy and France recorded growth. Current-period data indicated a deepening manufacturing downturn accompanied by a sharp deceleration in the (relatively robust) service sector. Meanwhile, after shrinking in three of the previous five quarters, the Japanese economy recorded above-trend growth of +2.7% (annualized) between January and March, boosted by a weak yen and surging tourism arrivals. Purchasing-managers surveys continued to climb through April, though the latest readings indicated flagging momentum. Following the abrupt lifting of COVID-related restrictions just before yearend, the Chinese economy sprang back to life, growing at an annualized rate of better than 9% in the January-March quarter. More recently, the recovery appeared to sputter, however, as a widespread property-sector malaise re-emerged following several better months fueled by pent-up demand resulting from last year’s pandemic lockdowns.
Inflation continued to abate, though progress on that front appeared to slow. Headline consumer-price inflation in the U.S. eased to an annual rate of +4.0% in May (compared to +6.0% in February and a peak of +9.1% last September). However, the less volatile “core” CPI and core personal-consumption-expenditures (PCE) measure (preferred by Federal Reserve officials) both hovered between 4% and 5% – well above the Fed’s 2% target. Noteworthy inflation factoid: an index of global supply-chain pressures compiled by the Federal Reserve Bank of New York hit a record low in May – completing a round-trip from the all-time high recorded in December 2021, when fleets of container ships lined up offshore jammed U.S. ports.
As the April-June quarter began, investors nervously eyed the U.S. banking system following the failure of several regional banks during March. The mood gradually improved as late-April earnings reports indicated a slowing rate of deposit outflows, while several salutary asset-sale transactions were announced later in the period. Bank stock prices staged a partial recovery, though the financial-services sector remained the worst-performing industry group year-to-date: an exchange-traded fund tracking a basket of regional bank stocks ended the period 30% below its yearend level.
With inflation remaining uncomfortably high and fears of a widening financial crisis abating, the world’s central banks continued the most aggressive policy-tightening campaign since the 1980s. Having raised overnight interest rates a cumulative 500 basis points (five percentage points) at its previous ten policy-setting meetings, the U.S. Federal Reserve opted to “pause” rate increases in June. However, “quantitative tightening” continued, as the bank let maturities shrink its massive holding of Treasury and mortgage-backed bonds by nearly $100 billion per month, and Fed officials signaled plans for additional rate hikes later this year. Elsewhere, European and U.K. central bankers pressed ahead with raising rates, while their Canadian counterparts rejoined the tightening game in June after sitting it out at their prior two meetings. (The Japanese and Chinese central banks, concerned respectively with a lapse back into deflation and flagging growth, remained in accommodation mode.)
Using the definition of a 20% rally following a 20% decline, the S&P 500 entered a new bull market on June 8th (the preceding bear market bottomed in October 2022, after a decline of just over 25%). On June 12th, the index closed at a 52-week high for the first time since January 2022 – the longest such streak since 2009. Although some broadening was evident in June, this year’s market advance has been remarkably narrow, powered by a handful of mega-capitalization technology/communications/media stocks (e.g., Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla). According to research provider Strategas, the market-cap concentration of the top five stocks in the S&P 500 reached a record-high 24% in late June (compared with 18% at the peak of the 1999-2000 dot-com bubble); those five stocks had provided a whopping 70% of the index’s year-to-date gain. Through the first six months of the year, the cap-weighted S&P 500 Index outperformed its equal-weighted counterpart +17% to +7%; the Nasdaq 100 (QQQ) gained +39%, beating the meager 4% rise managed by the Dow Jones Industrial Average by the widest margin since QQQ began trading in 1985. In the bond market, credit spreads (i.e., the extra yield investors require to compensate for default risk) remained wider than the narrows seen prior to the banking crisis – a potentially noteworthy failure to “confirm” recent stock-market gains.
Earnings reported by S&P 500 Index constituents during the quarter (mostly covering the first three months of the year) came in just 1% below the year-ago figure – beating estimates that had been ratcheted back earlier in the year. Similar small declines are expected over the remainder of 2023, while Wall Street analysts have penciled in a gain of nearly 10% for 2024.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the +8.7% S&P 500 total return?
Second Quarter (April-June) 2023
+ Change in Earnings
+ Change in Valuation
= Total Return
Our read: Aggregate stock-market valuation has returned to nose-bleed territory, raising the bar on further gains, particularly in light of rising bond yields.
As is often frustratingly true, the midyear investment landscape makes eminent sense with the benefit of hindsight: “surprising” stock-market gains came as both regional-bank and debt-ceiling “crises” were averted, both the economy and corporate profits held up better than expected, and inflation continued to ease. In response, uncertainty surrounding future Fed policy abated and longer-term bond yields moderated, pushing equity valuations (i.e., what investors are willing to pay for future earnings) higher. All that, plus “generative AI.” So much for the rear-view mirror; visibility out over the hood is, as usual, not as clear-cut.
On the economic front, we wonder if the outlook is for recession avoided or merely postponed. Investors have been anticipating recession for more than a year, but with each passing month the threat seems to recede into the future. Nevertheless, nearly all historically useful forward-looking indicators continue to flash yellow – if not red: the Conference Board’s index of leading economic indicators has declined for 14-straight months – the third-longest streak on record – while the ratio of leading to coincident indicators has made repeated five-year lows since February; the new-orders components of purchasing-managers surveys are deeply depressed; in the Treasury market, both 3-month/10-year and 2-year/10-year yield curves are more steeply inverted than any time since the early 1980s – and both inversions have persisted longer than all but a handful of prior occurrences. Meanwhile, Fed tightening to date is yet to be felt across the economy (“long and variable lags”) – while Powell & Co. have promised more on the way (see below). And despite the apparent skirting of a crisis, the banking sector remains plagued by weak profitability, underwater commercial real-estate loans, and the likelihood of enhanced regulatory capital requirements – all pointing to a potential credit crunch ahead.
The seemingly resurgent housing market could be telling a different story, however, which bears continuing scrutiny. Because of its acute sensitivity to interest rates, labor intensity and tendency to drive related investments in durable goods, residential real-estate has historically led the U.S. economy into (and out of) most recessions. To wit, homebuilder stocks bottomed almost nine months ago and have since surged more than 80%; the National Association of Homebuilders index reached a low in December and has risen each of the past six months; nationwide house prices declined for seven straight months, but have notched gains in each of the last three; finally, housing starts declined for twelve months through April, but surged a whopping 21% in May. If that last reversal holds it would be especially noteworthy as starts have never bottomed prior to the onset of a recession.
As for the future of the Fed’s battle against inflation, the revised consensus is that interest rates will be “higher for longer” – but perhaps not much longer. The Fed’s most recent “dot plots” – the central bankers’ best guesses about the future – indicated that following June’s “pause,” rates will rise another 50 basis points (half a percentage point) before yearend. Confirming the currently hawkish view, chair Jay Powell recently averred rather unambiguously: “Although policy is restrictive, it may not be restrictive enough and it has not been restrictive for long enough.” Bond investors have moved closer to the Fed’s view: since May, market-implied expectations of rate cuts this year all but evaporated. But market participants still doubt the central bank will need (or dare?) to keep rates elevated much beyond yearend: the late-2024 level is projected to be nearly a full percentage point lower (around 3.75%) than the Fed’s dot-plot view (around 4.60%).
How will this persistent disagreement be resolved? While the growth/employment side of the equation will remain on their radar, we think the Fed will focus on reported, actual inflation in the wage-sensitive service sector, on one hand, and measures of inflation expectations (both survey- and market-derived), on the other. Recent wage data have been ambiguous though far from alarming: average-hourly-earnings gains (reported monthly) hovered around 4.4% (annual-change), compared to 5.4% a year ago, while the (quarterly) employment cost index ticked up a tenth of a percent to +1.2% (roughly 5% annualized). Meanwhile, it’s almost impossible not to be encouraged by developments regarding inflation expectations. Recent survey evidence (compiled by the University of Michigan) showed one-year expectations falling to the lowest level (3.3%) in nearly two years, though five-year expectations nudged slightly higher (to 3.1%). In the bond market, the 5-year/5-year-forward rate (i.e., what market yields imply inflation will average over the five years beginning five years from today) was recently 2.28% – trivially above the level that prevailed in 2018. More significant than its level, this measure has been in a falling and narrowing range since peaking in April 2022, indicating investors are less concerned (falling level) and their confidence in that view has increased (narrowing range).
In sum, we see a half-empty glass: the combination of a hawkish Fed and persistent recession-warning signs modestly outweighs an improving housing market and what we judge to be a benign inflation outlook. Market participants in aggregate, however, don’t seem to share our measured pessimism: rising bond yields, narrowing credit spreads and robust – even if narrow – stock-market gains are clearly more consistent with an elusive “soft landing” than a more dire outcome. Moreover, individual investors, who had been stubbornly skeptical of the nine-month market advance, seem to be changing their tune: according to the American Association of Individual Investors, bullish sentiment recently exceeded 40% for the third week in a row for the first time since mid-2021 (it hasn’t cracked above 50% for 113 consecutive weeks). Meanwhile, June's Consumer Confidence report marked the first since January 2022 in which more respondents expected higher stock prices than lower stock prices in the months ahead. If a full-fledged FOMO (‘fear of missing out’) sensibility returns to the markets, recent gains could have further to run.
We believe the 20%+ run-up in stock prices since October 2022 largely prices in a rosy scenario where inflation continues to fall and the economy continues to skirt recession – a plausible though narrow path requiring a lot to go right. We think economic growth is likely to falter in response to determined monetary tightening. Meanwhile, historically high corporate profit margins are arguably set to come under increasing pressure from rising interest costs and much-needed investments related to the energy transition and geopolitical “de-risking” of supply chains. Finally, at 19-times year-ahead expected earnings, aggregate stock-market valuation is challenging – rarely has it been appreciably higher outside bubble territory (e.g., 1999-2000). We think the above set-up poses a high bar for stocks to generate better-than-average returns over the next year or two – with considerable downside risk should a recession and meaningful drop in earnings occur. Accordingly, we will continue to monitor equity holdings closely, weighing them against what have become increasingly attractive alternatives: short-term Treasury and government-sponsored-entity yields above 5%; high-quality three- to five-year taxable bonds better than 4.5%; and lesser-quality/high-yield credit instruments in the 8% to 9% range. And we will continue to maintain flexibility to react opportunistically via ample holdings of highly liquid short-term instruments.
We hope you are enjoying summer. Please call or email any of us if you have questions or suggestions regarding your investments.