By: Darren W. King | Wealth Management
Equity markets staged a historic rally in the second quarter, as inflationary numbers continued easing off the peak inflation experienced during last summer and as economic growth surprised to the upside. The S&P 500 rebounded 16.8% during the first half of the year. The Technology-heavy NASDAQ led the market recovery up 32.3% for the first half of the year, while the DOW Jones Industrial Average was up only 4.9% through the second quarter. The Russell 2000 Small Cap Index was up 8.06% over the same period. International developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE), closed the second quarter up 11.67% in US dollar terms and up 12.10% in local currency. The MSCI Emerging Markets Share Price Index closed 2Q2023 up 4.89% in US dollar terms.
2022 saw high valuation technology, internet commerce and growth shares in general lag the overall market. The first half of 2023 saw these same sectors, hit hardest in 2022, post the strongest recovery on optimism for the rise of adoption of AI technology. S&P 500 sector results through 6/30/23: Technology 42.7%, Communication Services 36.2%, Consumer Discretionary 32.9%, S&P 500 16.88%, Industrials 10.18%, Materials 7.74%, Real Estate 3.72%, Consumer Staples 1.28%, Financials -.53%, Health Care -1.48%, Energy -5.55% and Utilities -5.69%. Subtracting out the tech stock rally, equity markets made little ground during the first half of the year, as returns were concentrated in 2022’s laggards, while value and defensive stocks sold off.
Based on current consensus earnings forecasts, the forward 12-month P/E ratio for the S&P 500 is 18.9X, more expensive than the ten-year average P/E of about 17.4X. Currently, the market is estimating .9% earnings growth on 2.4% revenue growth in 2023. Much of the recent rally in the equity markets has been liquidity driven. Investors have put high cash levels back to work as the economy and corporate earnings have remained more resilient than worst case fears as a recession expected in the first half of 2023 has not yet materialized. Currently, second quarter annual earnings growth is estimated to be down 6.8% from the prior year while the current consensus calendar year 2023 S&P 500 earnings projection hinges on earnings growth returning to high single digit year over year growth by the fourth quarter. In short, equity markets are positioning for a trough in corporate earnings to occur this quarter with better growth prospects returning in the second half of 2023 into 2024. The recent rally in the stock markets also depends on a steady reversal of inflation numbers back towards the Fed’s 2% target and current trading levels depend on the fed being done with interest rate hikes this quarter along with interest rates trending lower into the future. For now, equity markets feel that the severity of any future recession has lessened over the course of this year.
During their June 2023 meeting, the Federal Reserve paused on further interest rate hikes, while also indicating that one or two more 25 basis points rate hikes were expected over the second half of 2023. Through May, the Federal reserve has initiated ten interest rate hikes, as the fed funds rate now sits at 5.00%-5.25%, the highest since 2007. Latest economic projections show an economy that is slowing following unprecedented stimulus during the pandemic. GDP grew 5.9% in 2021, 2.1% in 2022 and is estimated by the fed to be 1.0% in 2023, revised up from .4% GDP growth estimates assumed earlier in the year. GDP accelerated in the first and second quarter, coming in around 2% and providing evidence that monetary policy is not yet restrictive enough. Inflationary pressures are beginning to slow discretionary spending and eroding corporate profit margins. As measured by the Consumer Price Index, inflation ended the second quarter at 4%, down from 6% in first quarter, and appreciably below the 40-year high of 9.1% in June of 2022. However, much of the decline in inflation numbers has been the result of the rapid decline in oil and gas prices from the summer of 2022. All in, the Fed is willing to slow economic growth by increasing borrowing costs as it fights historic levels of inflation. Current forecasts are predicting a Fed Funds Rate around 5.65% by the end of 2023, 40 basis points higher than fourth quarter projections. While tighter financial conditions have hit parts of the economy, the labor market and consumer spending have remained much more resilient than what the fed had hoped for earlier in the year.
The 10-year treasury staged a slight rally during the first half of 2023; starting the year at 3.88% and ending the second quarter at 3.84%. Current intermediate treasury rates are now back to levels last seen in 2008. Longest duration bonds outperformed shorter duration issues as yields moved slightly lower across all maturities. Long treasuries returned 3.72% in the first half of 2023, while intermediate treasuries earned 1.10%. In a risk-on trade, higher credit quality underperformed the lowest credit quality issues. Aaa rated bonds within the Barclays U.S. Aggregate Index returned 1.69% in the first two quarters of 2023, while Baa rated bonds earned 3.54% during the same period.
The Bloomberg Dollar Spot Index weakened 1.09% in the first half of 2023, as international currency markets are expecting a pause in fed policy towards the middle of 2023. Light crude oil futures fell 12.2% thus far in 2023 over energy demand concern. WTI oil futures fell to $70.64 at the end of June from $80.45 at the end of the year. 30-year mortgage rates rose from 6.66% at year-end 2022 to 7.15% at the end of June, while 30-year treasuries fell 11 basis points from 3.97% at year-end 2022 to 3.86% at the end of the second quarter.
According to the Bureau of Labor Statistics, the June employment report showed 209k jobs gained during the month. This was the slowest monthly jobs number since 2020. The June jobs number reported unemployment at 3.6%, slightly above the February 2020 pre-pandemic rate of 3.5%, a 50-year low. The labor force participation rate in June was 62.6%, up from the pandemic trough of 60.2% in April of 2020. For June, hourly earnings rose 4.4%, below the recent wage inflation numbers averaging greater than 5% and indicating a slight cooling in wage inflation. The still hot jobs market, despite the Fed’s hiking policy, is keeping pressure on the Fed to raise rates higher. However, the recent jobs number showed the first signs of a labor market finally returning to reality.
Retail sales in May increased .3% from the prior month, better than estimates for a .1% decline as consumers rebounded with unanticipated positive spending on automobiles and building materials. Annualized retail sales were up 1.6% over the past year compared to the consumer price index’s measure of inflation up 4%. Gasoline station sales’ hit to discretionary spending finally abated as crude prices fell, with gasoline sales down 20.5% over the past year, increasing spending on other items. Department store sales were down 3.5% from the prior year. E-commerce and mail-order houses ended the 12-month period with a 6.5% sales gain. Auto sales were up 4.4% from the prior year. Restaurant spending was up 8%, furniture store sales were down 6.4%, health care spending was up 7.4% and clothing and accessories were down .2%. Despite a return to spending on restaurants and services since the pandemic shutdowns concluded, we expect real consumption growth to slow over the coming months, especially for big-ticket items related to housing. However, consumer spending on discretionary items remains resilient and better than most estimates coming into the year.
Equity markets continued to rebound off October market lows during the second quarter. Better than feared economic and earnings results fueled a liquidity rally as extreme defensive positioning was reversed. The most anticipated recession in economic history has yet to materialize. While odds for a recession are still elevated, especially in 2024, the current labor market and employment levels support the soft economic landing narrative. While we still believe that the AI tech stock rally has probably run to an extreme; it is important to note that this year’s concentrated growth rebound only moves growth stocks back to levels prior to the large correction in 2022. Through 2022 and half of 2023, the only positive economic sector has been energy stocks with the S&P 500 still down roughly 8% since market highs on January 3, 2022. In short, equity market levels are trading at roughly the midpoint between October 2022 lows and December 2021 market highs. We see equal odds for single digit gains or losses for equity markets moving forward. While growth valuations are elevated, small capitalization domestic equities and international stocks are trading at large valuation discounts to the mega-cap technology stocks that have led the market out of extremely bearish sentiment levels. We have started to deploy some of our elevated cash positions, back into equity markets, and will continue to add to equity exposure on any market weakness.
Within the fixed income markets, March of 2022 initiated a major shift in Fed policy as interest rate liftoff began in the first quarter of last year and is now close to a pause in the feds interest rate tightening program. However, this pause does not indicate that rates are moving lower anytime soon. With core inflation currently running around 5.3%, we expect the fed funds rate to end 2023 around the fed’s telegraphed rate of 5.50% to 5.75%. Inflation is remaining sticky while economic growth and tight labor conditions are still not restrictive enough for the fed. While interest rates fell during the first quarter of the year and the bond market was pricing for recession and interest rates cuts in 2023; most of the bond market rally has retreated and investors are now seeing a much tougher road to moving inflation back down to the fed’s 2% target. Following these developments, the 2-year treasury started 2023 at 4.43% and has risen to 4.99% today (July 13). The 10-year treasury has risen from 3.88% at year end to 4.04% today, while the 30 year treasury has risen from 3.97% to 4.00% today. Fixed Income market strategists now see the fed funds rate hitting 5.50-5.75% by year end 2023, while remaining above 3.50% well out to 2025. The Moody’s Seasoned Aaa Corporate Bond yield, currently at 4.69%, is at the highest levels seen in a decade, but has fallen from recent highs in November of 2022 at 5.09%. Longer duration interest rates look to have peaked in the last quarter of 2022. In our opinion, the fixed income markets still offer yields that provide an alternative to equity only investing that has not presented itself in the last decade’s low interest rate environment and would provide a hedge to any severe equity market correction and recession selloff. In such a scenario, the fed would lower rates sooner and bond prices would provide some cushion to any equity losses.
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Click here to read the Q2 2023 Market Summary.
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Data Sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Dept. of Commerce (GDP, retail sales, housing); Institute for Supply Management (manufacturing/services). Factset (S&P 500 statistics); Performance: based on data reported in Bloomberg (indexes, oil spot prices, foreign exchange); News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources, such as government agencies, corporate press releases, or trade organizations. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied upon as financial advice. Forecasts are based on current conditions, subject to change, and may not come to pass. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.