Thoughts on the Investment Markets – Q2 2023

• Higher Yields continue to make bonds a compelling asset class

• The Fed decided to take a pause as Inflation continues to moderate

• Stocks continue to perform well driven by exuberance around AI

Imagine if we could have asked you in January to predict how the markets would fare by the mid-point of this year. What do you think you would have said? What if we could have told you then that by the time we reached the end of June, we would have already seen the largest bank failure since the Global Financial Crisis,¹ the U.S. Government would be on the brink of default,² the Yield Curve would be as inverted as it has ever been since 1981,³ the Fed would raise interest rates three more times,⁴ and inflation would still be well above the target rate?⁵ Rationally, you may have predicted that, with all the uncertainty created by this series of events, performance in the capital markets would be poor. And yet, through the second quarter, investors have seen a stark reversal from the losses incurred in both stocks and bonds last year. The Dow Jones Industrial Average and S&P 500 have risen 3.8% and 15.9%, respectively. However, it’s the tech-focused Nasdaq Composite which has seen its strongest first half performance in 40 years, returning 31.7%.⁶  Although bond performance is currently being outshined by equities, investors are taking advantage of opportunities in both the Treasury and Corporate bond markets not seen in well over a decade.⁷

While the market resilience of the past six months may feel like an anomaly, history has demonstrated time and again that investors who take a long-term approach to reach their financial goals have been rewarded for their patience and perseverance. As Warren Buffet once said, “The stock market is a device to transfer money from the ‘impatient’ to the ‘patient’.”⁸  Over the past 32 years, in the face of various geopolitical tensions, pandemics, natural disasters, terrorist attacks, economic crises, and wars, the S&P 500 has produced a cumulative return of 2,253%.⁹  We believe the lesson you can take away from this is to develop a financial plan you can adhere to even during times of elevated uncertainty.

Economic Review & Outlook

For the better part of the last year and a half, one of the most widely discussed and debated subjects among investors has been the monetary policy of the Federal Open Market Committee. At its June meeting, the Fed chose to take a pause on raising interest rates for the first time after ten consecutive moves in as many meetings.¹⁰ While the Fed’s decision may be an indication that the hiking cycle is reaching its peak, Chair Powell has stated that the potential for future hikes is still a viable option as the committee continues to monitor economic conditions. In fact, the Fed’s “dot plot”, the forecast for future hikes within the Summary of Economic Projections (SEP), shows that the majority of committee members still believe that two additional hikes will be necessary before the end of the year.¹¹ Market participants are currently forecasting a 93% probability that the July meeting will result in an additional hike of 25 basis points, bringing the Fed Funds Rate to a range of 5.25% - 5.50%.¹²

We believe that while the Fed may not be through with its restrictive policy, it’s clear that the efforts to fight inflation are having their intended effect. For the 12th consecutive month, inflation, as measured by the Consumer Price Index (CPI), slowed to an annual rate of 3%; a far cry from the 9.1% peak inflation rate in June 2022.¹³ The Fed’s preferred inflation gauge, the PCE Price Index, rose 3.8% year-over-year in May, down from 4.3% in April.¹⁴ Additionally, the Labor Department’s June jobs report showed that Nonfarm payrolls increased by only 209,000, a significant decrease from the 339,000 jobs added in May. Economists had projected 240,000 positions would be added this month. However, even with jobs report coming in lower than expected, the unemployment rate decreased month-over-month from 3.7% to 3.6%.¹⁵

Source: Federal Reserve Bank of St. Louis

Bond Market Review & Outlook

Return data provided by Morningstar Direct

We believe if there was a silver lining to what has been called the worst-ever year on record for U.S. bonds in 2022, it’s that investors are now able to take advantage of the higher yields driven, in large part, by the Fed’s monetary policy.¹⁶ Treasury yields continued to rise throughout the quarter, especially in the 2-year, which can be viewed as a proxy of Fed action, rather than longer dated bonds. 2-year Treasury yields rose from 4.06% to 4.87%, and 10-year Treasuries ended the quarter at 3.81%, up from 3.48%.¹⁷

Much of the financial news during the second quarter centered around the debt ceiling. Fortunately, after a series of last-minute negotiations, a deal was finally reached preventing the U.S. Government from defaulting. While disaster was largely avoided, the consequences of the Treasury needing to take drastic actions to continue to pay its obligations left the Treasury General Account (TGA) with a balance of less than $50 billion. For context, the Treasury typically targets a balance in the TGA of $500-$600 billion.¹⁸  Held at the Federal Reserve, the TGA is the account the Treasury uses to pay the country’s bills. It is expected that the Treasury could issue over $1.4 trillion in short-term T-bills to replenish the account.¹⁹ This flood of new treasuries, coupled with the effects of tightening monetary policy, could create a temporary reduction in capital market liquidity. This may lead to a potential increase in volatility in the intermediate term while the market reaches equilibrium.

Source: Federal Reserve Bank of St. Louis; The Department of the Treasury; ($ in Billions)

Stock Market Review & Outlook

Return data provided by Morningstar Direct

U.S. stocks continued to perform well, especially towards the end of the second quarter, as inflation continues to moderate, and the economy remains resilient despite higher interest rates. With the unemployment rate near half-century lows,²⁰ and the recent upward revision of Q1 GDP from an annualized rate of 1.3% to 2.0%,²¹ investors are optimistic about the future performance of the market.

Much of the advance has been driven by the Information Technology and Communication Services sectors, with the so-called “Magnificent 7”, including Nvidia, Tesla, Alphabet, Apple, Meta, Microsoft, and Amazon, accounting for a significant portion of returns.²² Although Artificial Intelligence has been around for years, the advent of ChatGPT, and other generative AI, has provided a tailwind, particularly for companies that manufacture the semiconductors used for processing and storing massive quantities of data. While the long-term implications of AI are anyone’s guess, the potential for companies to leverage its powerful applications may provide opportunities for growth across various industries. In this scenario, the breadth of companies driving performance could widen, thereby reducing the concentration of returns and making market-cap-weighted indices like the S&P 500 less top-heavy.

We also continue to see opportunities in global equities. Not only do international companies provide the benefit of geographic diversification, but valuations continue to remain well below long-term averages, pushing dividend yields higher relative to US stocks, and creating attractive entry points for investment.²³ After the first half of the year, international equity performance, as measured by the MSCI All Country World Index ex USA Index, is up nearly 10%.²⁴

Alternative Investments & Hybrids Review & Outlook

Alternative investments were one of the few areas in the market investors could look for positive returns last year as their low correlation to traditional asset classes provided a much-needed ballast to portfolios. The performance across alternative strategies has been mostly positive over the first half of 2023 as well. However, Real Assets, which include global property, infrastructure, and commodities were down for the quarter, as oil prices are near their lows for the year due to a lack of global demand.²⁵ Since October, OPEC+ has cut its production by 3.5 million barrels per day but China’s rebound from its Zero COVID policy has been lower than analysts expected.²⁶

Commercial Real Estate, specifically office buildings, has garnered the attention of investors as the asset class has underperformed relative to multifamily and industrial properties. The shift to working from home, caused by the pandemic, only accelerated what were already rising vacancy rates in office buildings. Since regional banks are one of the primary providers of financing for offices, there has been speculation that additional bank failures may be imminent as borrowers refinance in a higher interest rate environment. A recent report from JP Morgan states that small banks hold 4.4 times (28.7% of assets) more exposure to U.S. commercial real estate loans than their larger peers.²⁷ While this is a situation we will continue to monitor, we believe it is important to keep in mind that both lease renewal cycles and loan refinancings are staggered which spreads the potential risk to banks over many years.

Conclusion

We have never had the level of access to real-time information as we do today. One simply needs to go to the airport or a sporting event or even a restaurant and you can be assured that the majority of people you observe will have their faces buried in their phones keeping up to date on any number of topics. In many ways, this is a blessing, as it is critical to stay informed of what is happening around the world. But it can also be a curse to be inundated with a 24-hour news cycle full of “experts” who provide conflicting opinions on both the current state of affairs and where they believe we are heading next. And yet no matter how convincing pundits can be, their crystal ball is no clearer than anyone else’s. As Mark Twain once said, “Prophecy is a good line of business, but it is full of risks.”

As we look back over the last six months, we are reminded that uncertainty is one of the few elements of life which we can all take for granted. There have been numerous events which have left investors concerned that the strong performance we saw in the markets at the beginning of the year would be short-lived. And yet, as we enter the second half of the year and beyond, we believe there are reasons to be cautiously optimistic. For one, although the road to get here has been painful, the Fed’s aggressive monetary policy has taken the annual inflation rate from its peak of 9.1% in June of last year to 3% in 2023; a two-thirds decrease in just 12 months. Additionally, the economy continues to prove that it’s not only resilient but growing with unemployment near 50-year lows, hundreds of thousands of jobs being added every month, and stronger real GDP growth than analysts expected. 

While it’s only natural to feel overwhelmed at times by the bombardment of information we constantly receive, we believe that developing a comprehensive financial plan that you can adhere to, especially during turbulent times, is the best way to withstand the dynamic nature of the markets. It has been said that fortune favors the bold, but as history continues to demonstrate, fortune actually favors the persistent.

This information is for educational purposes and is not intended to provide, and should not be relied upon for, accounting, legal, tax, insurance, or investment advice.  This does not constitute an offer to provide any services, nor a solicitation to purchase securities. The contents are not intended to be advice tailored to any particular person or situation. We believe the information provided is accurate and reliable, but do not warrant it as to completeness or accuracy.  This information may include opinions or forecasts, including investment strategies and economic and market conditions; however, there is no guarantee that such opinions or forecasts will prove to be correct, and they also may change without notice.  We encourage you to speak with a qualified professional regarding your scenario and the then-current applicable laws and rules.

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23. JP Morgan Guide to the Markets (Q2 2023)
24. Morningstar Direct
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