U.S. stocks continued higher during the second quarter as large capitalization growth names, specifically those involved with artificial intelligence, soared. The S&P 500 returned 8.7%. Smaller company stocks increased 5.2% as that segment of the market shrugged off many of the banking-related concerns from the first quarter of this year.
International stocks turned in more modest returns for the quarter, increasing 3.4%. Emerging markets advanced only 0.9% while developed market stocks outside of the U.S. returned 3%.
Bonds declined 0.8% during the quarter, but remain positive by 2.1% on a year-to-date basis. Interest rates picked back up from near their lows for the year at the beginning of the quarter, driving declines in bond prices. Higher rates were largely driven by the Fed’s positioning of “higher rates for longer” to further combat inflation.
The Fed raised interest rates another 0.25% in May, before “pausing” during their June meeting. However, expectations around the Fed’s stance have generally trended towards more restrictive monetary policy by the end of the year. There remains optimism that a “soft landing” can still be achieved, whereby higher interest rates can further slow inflation, while not meaningfully harming the labor market or ultimately causing a recession. We are less convinced than others that this will be achieved, as historically the Fed has struggled to thread this needle. Monetary policy tends to operate with long and variable lags, and we are coming off a period of strong above trend growth, so at this point it may just be a matter of time. On average, recessions usually begin 12-18 months after the yield curve becomes inverted, which occurred in July 2022. One of the emerging theories is that rather than a more traditional recession that tends to hit most sectors simultaneously, we will instead face a series of less severe “rolling recessions” across sectors of the economy. In some ways this sounds more palatable than a traditional recession, but we remain skeptical.
While inflation has been a hot topic over the last several years, the Fed has made substantial progress in bringing down inflation over the last twelve months. As of the time of this writing, the most recent inflation print showed inflation cooling to 3.1% over the past twelve months. Compare this with the June 2022 report (available here) which came in at an 8.9% annual rate – the highest level since 1981. Inflation does still remain above the Fed’s 2% target, but we are clearly moving in the right direction.
The disinflationary benefits of the Fed’s rate hikes may be obvious, but it also bears mentioning that there have been pockets of weakness across the global economy which are at least partially a function of tighter monetary policy. Fortunately, we seem to have made it through the bank failures without the proverbial “other shoe dropping” (at least so far), though we remain mindful that we will likely see an impact on credit creation as banks pull back on risk-taking activity. Another area that we are watching carefully is commercial real estate where concerns around post-pandemic changes in the way we work could have a significant impact on property values. Earnings have continued to come in above expectations. As it stands, the second quarter is expected to be the third consecutive quarter of year-over-year earnings contraction for the S&P 500. Stocks have continued to rally as actual earnings have exceeded what could certainly be characterized as a low bar. Expectations for the second half of this year and for 2024 will likely provide a much higher hurdle for positive surprises. Markets are pricing in a 0.4% earnings contraction for full-year 2023, followed by 12%+ earnings growth next year.
At the beginning of the quarter, there was some concern in the markets surrounding the U.S. debt ceiling negotiations. During the first week of June, Congress ultimately approved new legislation to suspend the debt ceiling. The employment level in the U.S. remained stable during the second quarter after three years of large, albeit decelerating increases. The unemployment rate ticked up slightly from the lows of the cycle. Elsewhere in the economy, industrial production, manufacturing and trade industry sales and retail sales are all off their highs and in some cases declining or in outright contraction.
In our view, the relative value between stocks and bonds has shifted meaningfully over the past 18 months. As a result, we began to transition to a small underweight to stocks at the end of the second quarter.
As noted previously, we began adding stand-alone U.S. treasury bond positions back into client portfolios early last year for the first time since the first quarter of 2020. We are further increasing that allocation as we believe that while bonds are relatively attractive when compared to U.S. stocks, credit spreads (the additional yield above treasuries for riskier bonds) in non-treasury sectors of the bond market are not attractive enough to warrant increasing our overweight to these areas.
While markets have performed very well from the bottom in mid-October, we are concerned by both elevated valuations and a heightened likelihood of recession. Last year was one in which fear ran rampant, while this year we are beginning to see quite a bit of optimism amongst investors as economic data and earnings have been less negative than was expected. In order to avoid panicking when things feel as though they could only get worse, and complacency when others become overly optimistic, we think it is important that investors maintain discipline and a utilize a long-term valuation-driven framework. The path forward from here remains highly uncertain, and we are grateful that you entrust us with the responsibility to continue to shepherd your assets through that uncertainty.
Please do not hesitate to reach out with any questions about your portfolio, plan or markets. Enjoy the rest of your summer and stay cool!
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