Bucking concerns surrounding rising interest rates and the state of the global economy, the S&P 500 has pulled off its third-best start to the year over the past 25 years. Key driving factors have included decelerating inflation, a growing possibility of a non-recessionary, soft landing, an impressive tech stock rally, and signs that the Federal Reserve may be nearing the end of its tightening cycle.
The S&P 500 closed on June 30th at 4,450, representing a strong return of 8.74% for the second quarter and 16.89% for the first six months of 2023. The less technology-heavy Dow Jones Industrial Average (DJIA) posted much more muted gains and ended June at 34,408 for a return of 3.97% in the past three months and 4.93% for the year-to-date.
Under the surface, however, the rally has not been an equal participation one. At the start of June, analysis indicated that market breadth, which reflects how many stocks participate in the upside moves, had meaningfully narrowed, prompting some concern about underlying fundamentals. At the beginning of this month, eight of the largest U.S. tech and growth companies, the usual household name suspects, accounted for 30% of the S&P 500’s market capitalization, up from around 22% at the start of 2023. Illustrated a different way, at the end of May, the universally cited market-capitalization weighted S&P 500 (over which these big tech companies exert an outsized influence) was outperforming its equal-weighted counterpart by nearly 10%, the biggest margin of outperformance for the time period on record, according to Dow Jones Market Data. Essentially, with the earnings recession of last year stabilized, the markets shifted toward a more risk-on trend.
By mid-June, the phenomenon had abated somewhat, with a broadening stock market rally leading to improving market breadth with over 55% of stocks in the S&P 500 trading above their 50- and 200-day moving averages. Still, going into the final week of this quarter, the Large Cap Growth segment of the equity market was significantly outperforming all other styles year-to-date, up over 27%, and blowing away Large Cap Value at a 2.9% gain. In terms of sectors, Information Technology was the big winner, up 40.3% in the same time frame, and Energy has been the clear laggard, down 9.1%. Part of tech’s outsized rally is a surge of investor interest in the Artificial Intelligence (A.I.) craze, as well as signals pointing to a less aggressive Fed going forward, meaning peaking interest rates on the horizon.
At the Fed’s June meeting, the Federal Open Market Committee (FOMC) decided to leave the federal funds target rate unchanged at a range of 5.0% to 5.25%. This pause marks the first meeting at which the FOMC has not raised interest rates since it began its tightening cycle in March 2022. It marked what is viewed as a temporary hiatus following ten consecutive rate increases over the last fifteen months. The Fed also confirmed its commitment to quantitative tightening, allowing $60 billion in Treasury securities and $35 billion in mortgage-backed securities (MBS) to roll off its $8.3 trillion balance sheet every month.
The Fed’s current projections imply a median estimated terminal rate of 5.6%, an updated economic growth estimate of 1.0% (from 0.4%), core PCE inflation of 3.6% (from 3.9%), and a lowered unemployment rate forecast of 4.1% (from 4.5%), all by year-end. Fed Chair, Jerome Powell, reiterated that inflation remains too elevated for the Fed’s liking and believed strong support existed for additional rate hikes in order to help reach the central bank’s 2% target. In mid-June, the Labor Department reported the consumer price index (CPI) rose at an annual rate of 4.1% in May, down from 4.9% in April and well below the 40-year high of 9.1% in June 2022. Energy price declines were a contributing factor, while shelter prices remain stubbornly elevated.
At an event hosted by the Spanish central bank in Madrid at the end of June, Mr. Powell said: “we expect the moderate pace of interest rate decisions to continue,” after the June pause. The case for enacting hikes may, however, weaken if inflation continues to recede and the impact of this cycle’s monetary tightening becomes fully felt.
In Congress, President Biden and Speaker Kevin McCarthy reached an 11th-hour deal at the end of May to suspend the federal government’s $31.4 trillion debt ceiling until January 2025. This allows the government to continue borrowing money in order to pay its bills on time. Central to the hard-fought compromise was a two-year budget deal that essentially holds spending flat for 2024, while boosting it for defense and veterans, and capping increases at 1% for 2025. Also, in breaking news at the end of the quarter, the Supreme Court decided 6-3 to vote against President Biden’s plan to dissolve $430 billion in student loan debt. Federal student loan payments, having been on a three-year hiatus that started in the early months of the Covid-19 pandemic, are expected to resume later this year, which could dampen consumer spending.
A positive trend has been an abatement of the earnings recession that caused malaise in the markets for much of 2022. The disinflationary trajectory has positively impacted margins, coupled with cost-cutting initiatives including layoffs, and a resilient economy have all helped support bottom lines and lifted the S&P’s forward earnings estimate off its recent low of $226 to around $232. Second quarter earnings results will be very telling, allowing investors to better gauge the real impact of recently documented economic and consumer headwinds, including downward pressure on tech spending.
Talk of an impending recession is still weighing on economic outlooks, but from a worker standpoint, the labor market remains strong by any historic measures. Data from the U.S. Bureau of Labor Statistics showed the national unemployment rate ticked up slightly by 0.3% in May to reach 3.7%. But, at the end of June, the Labor Department reported an unexpected decline in jobless claims with the number of Americans filing new claims for unemployment benefits falling by the most in 20 months in the latest sign of the economy’s resilience. Raymond James’ economist still holds the stance that a recession is more probable than not, although recently pushed out the likely beginning to the fourth quarter of 2023 from the third quarter.
After the massive ramp-up in interest rates last year, bonds continue to present some attractive investment opportunities both outright, and compared to equities for income-seeking investors. With the recent equity market rally, the S&P earnings yield (inverse of the price-earnings ratio) has dipped to 5.3%. This may be compared to the U.S. corporate bond index, which stands at 5.1%, or cash instruments offering a yield of around 5%. Historically, earnings yields exceed bond yields as investors seek to be compensated for the added risks of taking equity positions, but we are now in the unusual position of the two yields converging. But, if economic data disappoints, we could see a reversal of recent flows into equities.
The rise in bond yields and the hawkish stance of the Fed have exacerbated the U.S. yield curve inversion. The 10-year Treasury yield (3.84%) is over a full percent lower than the 2-year Treasury yield (4.86%), which is the deepest inversion since the early 1980s. While by no means a perfect indicator, yield curve inversions have correctly predicted the last six recessions, occurring within eighteen months of an inversion event. In this cycle, April 2022 marked the initiation, placing a recession onset by October, should the pattern play out.
Yield curve inversions have also presented in other countries, including the UK, Germany, Canada, and Australia. Many nations are facing the same inflationary pressures and similarly responding with rate hikes. This sticky inflation, coupled with slow consumer spending, has led to two consecutive quarters of economic contraction in the European Union, prompting some economists to declare a recession, albeit mild, with the European economy managing to avoid a serious downturn. As in the U.S., inflation is coming down in the region, although gradually, and the European Central Bank (ECB) is equally serious about getting back to its own 2% target.
The ECB’s quarter percentage rate rise in June to 3.5% marked its eighth consecutive hike and raised euro zone borrowing costs to their highest level in 22 years. Speaking at a press conference ECB President Christine Lagarde held firm, saying: “Barring a material change to our baseline, it is very likely the case that we will continue to increase rates in July.” Similarly, the U.K. and Canada have raised rates by over 4% since the start of this tightening cycle in September 2021, with them currently standing at 4.50% and 4.75% respectively. Japan continues to remain a stark outlier, sticking to negative interest rates at -0.1%, despite inflation ticking above its central bank’s target.
On the international stage, U.S. Secretary of State, Anthony Blinken, met with Chinese President Xi Jinping during a recent visit to Beijing. The tone of the meeting appeared to be positive and cordial, signaling a detente between the nations following a recent high point in US-China tensions, and also alleviating some global macro risks for the time being. Mr. Blinken stressed that “we both agree on the need to stabilize our relationship.”
Things appeared recently to be decidedly less stable for President Putin as Russia’s conflict with Ukraine rages on beyond sixteen months in what increasingly resembles a quagmire. In a surreal turn of events, on June 24th a sizeable group of armed mercenaries under the command of Yevgeny Prigozhin, the chief of the Wagner group of “private military contractors” who have been fighting for Russia against Ukraine, seized control of two Russian cities and came within 125 miles of Moscow. The band eventually withdrew unharmed and it was revealed that the mutiny had been in response to Mr. Putin’s attempts to force the Wagner group to come directly under the control of the defense ministry.
Following the brief show of force, Mr. Prigozhin retreated to Belarus with Wagner troops, supposedly with the Russian president’s go-ahead. Mr. Putin now appears to be set on re-establishing his authority with purges and shows of force, but the event was a blow to the image he seeks to portray as an iron-fist leader commanding absolute loyalty. The U.S. continues to support Ukraine in its counteroffensive. Since the war began in February 2022, the Biden administration and the U.S. Congress have directed more than $75 billion of aid to Ukraine, more than half of that figure in military and security assistance.
In conclusion, the U.S. economy has shown surprising resilience so far this year, but there are headwinds that may merit a degree of caution going forward for investors. Goldman Sachs CEO, David Solomon, recently expressed in an interview that economic conditions “might not be a recession, but it certainly would feel like a recession.” A hard landing might be avoided but markets would still be facing “sluggish growth and sticky inflation.”
As you know, here at Stolper Asset Management, we pay attention to macro factors but are not forecasters in that area. Instead, we take a bottom-up approach, identifying individual investment opportunities in durable businesses at fair value or below. Consequently, when the market is chasing richly valued growth prospects, such as has been the swing of investment sentiment lately, we do not fully participate in the upsides. But sentiment is fickle, and the pendulum will, at some juncture, point back toward value. Through these oscillations we remain confident in our approach and discipline as we act as wealth stewards for the long term. In the words of the famed value investor, Ben Graham, “The individual investor should act consistently as an investor and not as a speculator.”
We hope you weathered the recent storm here without lasting damage and are keeping cool in the summer heat. As always, we thank you for the continued confidence you place in us as your trusted financial advisor.