Halftime Report: Look How Far We’ve Come

Despite a barrage of hawkish central bank actions and “Fedspeak,” sticky inflation, a regional banking crisis, ongoing strife in Ukraine and Russia, and lackluster first-quarter earnings forecasts, equity markets defied expectations through the first half of 2023. The S&P 500 Index closed out the second quarter at 4,450 (up from 3,840 at the beginning of the year) and the Nasdaq—an index that focuses primarily on tech companies—is up over 30% year-to-date, fueled by a rally in artificial intelligence-related names. With U.S. technology stocks trading at around 28 times prospective earnings and roughly 40% above their 10-year average, is there still room to run? Or should investors start to look at other areas of the market for the next opportunity, given that non-mega-cap stocks in the S&P 500 are trading at a much more reasonable 17 times earnings?

A Hawkish Pause

In a widely expected move, the Federal Reserve (Fed) decided to hold off on raising interest rates last month following 10 consecutive increases. Fed messaging has been steadfast: There is still a long way to go to reach the 2% inflation target, and additional tightening may be necessary. During discussions at a European Central Bank forum, Fed Chair Jerome Powell noted that the Fed’s policy has not been restrictive for long enough, and that the central bank had paused to better evaluate the stresses associated with tightening 500 basis points since March 2022. Thus, there are strong signals that the Fed will resume action in July, with a 25-basis-point hike now considered a 95% probability (CME Group). Longer term, any shifts in the Fed’s viewpoint may become apparent next month at its Jackson Hole symposium, but continued moderation in prices and wage growth will be critical for Powell and his colleagues to “skip” again in September.

A look overseas helps with context. In England, upward inflation surprises (the worst levels since the 1980s) have led to unexpected policy rate hikes. In June, the Bank of England raised its benchmark rate by 50bps to 5%—the highest level in 15 years—and warned that it may have to hike again. While the U.K.’s financial situation is different from the U.S. in many ways, it can be viewed as a warning as to what could happen if the Fed were to relax its monetary policy too soon. Other central banks took similarly hawkish stances in June including the Swiss National Bank (+25 bps), Norges Bank (Norway, +50 bps), Bank of Canada (+25 bps), and the Reserve Bank of Australia (+25 bps).

Investors Largely Ignore Russian Uprising

The conflict between Russia and Ukraine showed no signs of cooling in June. Most notably, the Wagner Group, a private army fighting Ukrainian forces on Russia’s behalf, launched a short-lived rebellion in Russia. Wagner forces took control of a southern Russian city and marched towards Moscow. The uprising was only called off when the Kremlin said that the group’s leader, Yevgeny Prigozhin, would receive amnesty and allowed his exile to Belarus, narrowly avoiding what could have become a real threat to Putin’s rule. Though potential Russian weakness could have real implications for Ukraine’s military strategy, markets seemed to shrug off the news.

Significant geopolitical events were not limited to Eastern Europe. More recent news about potential restrictions on U.S. artificial intelligence chip exports and the use of cloud-computing services in China could have a significant impact on the marketplace over the medium to long term, perhaps dampening enthusiasm following a stellar first half of 2023 for semiconductor stocks such as Nvidia. In general, we believe geopolitical events may have short-term investment implications, and we will monitor them closely to determine if they warrant changing our longer-term expectations.

What Could Be Next?

Interestingly, history suggests that equity markets could continue to rise. The S&P 500 entered its twenty-seventh bull market (defined as a greater-than-20% return from the low) on June 8. According to Bank of America, since 1950, in the 12 months following a S&P 500 bull market, the index has moved higher 92% of the time with an average return of 19%. This dynamic can be explained by the “fear of missing out” (or FOMO), a colloquial way to refer to market momentum. This dynamic has been reflected in the velocity at which the market has traded higher, with the S&P 500 Index moving from 4,200 to 4,300 in just six trading days, then accelerating to 4,400 in only four additional days after staying primarily range-bound between 3,800 and 4,200 since October of last year. In our view, this momentum could have staying power, buoyed by investors looking to deploy excess cash held on the sidelines coming into the year. There has also been a shift in where the cash is being deployed. So far this year, the majority of S&P 500 strength has come from its top 10 largest constituents. In June, we saw this broaden out to the rest of the market as a basket of the bottom 490 stocks outperformed the top 10 for the first time this year. We believe this trend could extend the equity rally over the shorter term. Meanwhile, although central banks may be nearing peak interest rates, there could be lagging effects from sustained restrictive policy that have yet to materialize.

The Market Rally Broadened in June

Source: Bloomberg, As of June 30, 2023. Top 10 Stocks basket is made up of the top 10 largest stocks in the S&P 500 Index, as measured by their average weight YTD through June 30, 2023. The Bottom 490 Stocks basket is made up of the rest of the index when we exclude the top 10 largest stocks in the S&P 500 Index as described previously. These are market cap weighted baskets without rebalancing.

Mixed Signals in Search for Clarity

Despite economic conditions playing out as expected, the first half of 2023 defied both consensus expectations and our internal view. As noted, inflation has been sticky, central banks have been aggressive, economic growth has slowed, analysts’ corporate earnings forecasts have declined, and the dramatic rise in rates has caused unintended consequences (i.e., the collapse of Silicon Valley Bank, Signature Bank and First Republic) in the financial system. All of these negative dynamics would suggest that equity markets should have struggled. Yet, they rallied, with secular tailwinds from artificial intelligence boosting long-duration technology stocks.

Also surprising was the still resilient U.S. economy, as 1Q GDP was revised upward, consumer confidence was resilient, and jobless claims were kept in check. This suggests that rate cutes won’t be coming as soon as the market is pricing, although it’s worth noting that Personal Consumption Expenditures (PCE), the Fed’s preferred measure of inflation, came in cooler than expected for May, a sign that hawkish policy is having an impact on the price of goods.

Considering leading indicators, ISM Manufacturing PMI for June saw its eighth straight month of contraction, falling 0.9 points to 46 (anything above 50 indicates expansion). Production, employment, inventories and exports components were all lower, as were prices—perhaps the only bright spot in the report. Conversely, ISM Services PMI rose by 3.6 points to 53.9, led by strong readings in business activity and new orders; prices were also lower. This report supports the narrative, consistent with the decline in real retail sales in eight of the last 12 months, that consumers are still spending on services but have reduced their outlays on goods. The divergence between the two ISM measures—at its widest since August 2015—reflects the reliance of the U.S. economic rebound on consumer spending and, in our view, speaks to the challenge of looking to a manufacturing revival as a driver for domestic economic growth over the next six to 12 months.

The labor market also showed some signs of cooling via the surprising June Nonfarm Payrolls report, an important measure of job growth, which came in at +209,000 versus +230,000 consensus for its weakest print since December 2020. The relative softness was due in part to the addition of only 21,000 leisure and hospitality jobs in the month and was offset in part by the addition of 60,000 government jobs. In addition, the prints for April and May were revised down by a combined 110,000. However, despite the miss on payrolls, average hourly earnings and hours worked both came in higher than expected, the labor participation rate was stable and unemployment ticked down to 3.6% from 3.7%. This could indicate the early stages of a labor-market slowdown.

With this backdrop, we remain cautious but also acknowledge the uncertainty ahead over the next several quarters. As a result, we have moved from an underweight to a neutral view on equities with a continued emphasis on higher-quality and lower-beta (market) exposure. This move to neutrality is exactly that: We don’t think that the U.S. economy is out of the woods just yet, and we still think higher policy rates could affect economic growth, although the magnitude of that impact has yet to be determined. This late in the tightening cycle, we believe that investors can be defensive while still participating in equity markets, particularly as companies have been managing rising costs more effectively than expected thus far. We anticipate that additional lagging effects could materialize down the road, perhaps alongside financial “accidents” akin to the regional banking crisis. In our view, the Fed recognizes these challenges and continues to walk a tightrope that balances inflation, an economy that hasn’t shown clear signs of slowing, and potential for financial instability.

Equities Continue to Lead

Equities rallied in June with domestically oriented U.S. small- and midcap stocks leading the way. For the second quarter overall, however, U.S. large-cap growth stocks handily outperformed other segments of the equity market despite rising interest rates across the yield curve. As noted, we have moved to a market weight on equities as part of a general shift to neutralize our overall outlook and position clients closer to their long-term strategic asset allocations given ongoing economic uncertainty. Within equities, we still favor lower-beta, higher-quality names, with a neutral view on value versus growth. In this more challenging environment, we would also look to active management in order to select companies with high earnings visibility.

Fixed income markets notched modest gains in 2Q, with some areas of the market ending the quarter in the red. We continue to have a favorable view of non-Treasury fixed income (credit), maintaining an overweight view on investment grade securities. While there is still time to capitalize on higher short-term interest rates, clients should consider locking in higher yields at longer maturities. We recently downgraded high yield to balance risk in portfolios, as well as in view of recent spread-tightening that has reduced the asset class’s risk-adjusted return potential. Meanwhile, emerging markets debt remains an overweight given attractive relative yields and the potential to benefit from stable fundamentals, a more mature monetary cycle and stimulus in China.

Within private markets, we continue to favor private debt following the emergence of banking system stresses, as tighter financial conditions are beginning to generate opportunities for providers of liquidity. In contrast, we have downgraded commodities to neutral to balance out risk exposure added through our upgraded view on equities.

Source: Bloomberg, total returns as of June 30, 2023. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq Composite NASDAQ-Composite Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex US is represented by MSCI ACWI ex USA Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA US 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg US Agg Total Return Value Unhedged USD. Munis is represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg US Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg US High Yield BB/B 2% Issuer Cap Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg US Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg US Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg ExEnergy Subindex Total Return. U.S. 10-Year Yield is represented by US Generic Govt 10 Yr.