Investor confidence grew in the second quarter as most economists delayed the likelihood of a recession into 2024. This optimism led to an expansion in stock gains, driven almost solely by Big Tech. Without the exceptional returns delivered by Apple (AAPL), Microsoft (MSFT), and Nvidia (NVDA), the overall market would have remained stagnant. Through May, these three Tech giants were responsible for the most concentrated market ever recorded. By the end of the quarter, the rally expanded due to the positive performances of Eli Lilly (LLY), JPMorgan (JPM), and Adobe (ADBE).

In principle, the S&P 500’s growth of more than 20% from its 2022 low point constitutes the start of a new bull market. This momentum was supported by the Fed’s halt in interest rate hikes in June which led to a decrease in market volatility. However, the bond market presented a more varied scenario and experienced fluctuations in Q2 with the growing anticipation that the Fed will not only increase interest rates in the near future, but also maintain them at a higher level for an extended time to address continued inflation.

 

ECONOMIC CONDITIONS: U.S. – Resiliency

GDP: The economy’s total output in the first quarter was revised higher, from a 1.3-percent expansion to a 2.0-percent growth rate, casting doubt that the economy was headed to recession. [13]

LABOR: Employers added 339,000 new jobs in May, which exceeded the 190,000 consensus forecast. The unemployment rate jumped to 3.7 percent despite no change in the labor force participation rate. Year-over-year wage growth cooled to 4.3 percent. [14]

HOUSING: Housing starts rose 21.7% in May as low inventory boosted buyers’ interest and home builders’ confidence. It was the largest percentage gain since October 2016. [17]

Sales of existing homes fell 0.2%, while year-over-year sales dropped 20.4%.18 New home sales gained 12.2% in May, rising for the third consecutive month. [19]

 

INTERNATIONAL: Slowing Momentum

The European Central Bank (ECB) raised interest rates twice in the quarter, taking the main refinancing rate to 4.0%. Headline inflation declined during the period, with annual inflation estimated at 5.5% in June, down from 6.1% in May. However, the core inflation rate (which excludes energy, food, alcohol and tobacco prices) crept up to 5.4% in June from 5.3% in May.

Growth data showed that the eurozone experienced a mild recession over the winter, with GDP declines of -0.1% in both Q4 2022 and Q1 2023. Forward-looking data pointed to slowing momentum in the eurozone economy. The flash eurozone composite purchasing managers’ index (PMI) fell to 50.3 in June from 52.8 in May. That represents a five-month low and suggests the economy may be close to stagnation (50 is the mark that separates expansion from contraction in the PMI surveys).

U.S. EQUITIES: Stocks extended their rally in the second quarter, boosted by cooling inflation, the prospect of a shift in monetary policy, and enthusiasm over artificial intelligence.

For the three months ending June 30, the Dow Jones Industrial Average added 3.41 percent while the Standard & Poor’s 500 Index picked up 8.30 percent. The Nasdaq Composite, which led in the first quarter, led again, gaining 12.81 percent. [1]

DEVELOPED INTERNATIONAL EQUITIES: The MSCI-EAFE Index gained 1.87 percent in the second quarter as overseas markets were hobbled by persistently elevated inflation in multiple major markets and economic softness, exemplified by Germany entering a recession and a faltering China reopening. [10]

European markets were mixed in Q2, with gains in France (+1.06 percent), Italy (+4.12 percent), Spain (+3.90 percent), and Germany (+3.32 percent). The UK lagged, falling 1.31 percent. [11]

EMERGING MARKETS: Emerging market (EM) equities delivered a small gain over the quarter, which was behind that generated by developed markets. Tension between the U.S. and China was a contributing factor behind EM underperformance, as were concerns about China’s anemic economic recovery. U.S. debt ceiling uncertainty added to the negative mood, although this was resolved in early June. Pacific Rim markets were also mixed, with Hong Kong down 7.27 percent while Japan rose 18.36 percent. [12]

 

FIXED INCOME: A Hawkish Pause

U.S. FIXED INCOME: After raising interest rates unanimously by 0.25 percent following the March and May meetings of the Federal Open Market Committee (FOMC), the Fed elected to keep rates unchanged in June, pausing to assess the economic impact of the cumulative rate hikes to date.

Language in the rate announcement and comments by Fed Chair Powell indicate that, despite the pause, two more rate hikes are likely before the end of the year. [22] The U.S. 10-year yield rose from 3.47% to 3.82%, with the 2-year going from 4.03% to 4.87%.

DEVELOPED INTERNATIONAL FIXED INCOME: The ECB continued to hike interest rates and announced in May that they expected to end reinvestments under their Asset Purchase Program from July 2023. However, headline inflation has fallen significantly from the peak. Germany’s 10-year yield increased from 2.31% to 2.39%. Euro high yield outperformed investment grade over the period.

Inflation in the UK has taken many by surprise. This prompted the BoE to act more forcefully, raising interest rates by a larger than expected 50 basis points in June. The UK 10-year yield jumped from 3.49% to 4.39% and the two-year made even more gains by increasing from 3.44% to 5.26%. On the credit front, UK high yield outperformed UK investment grade.

QUARTERLY FOCUS: Narrow Scope

Let’s take a peek under the hood of this year’s rally to-date:

• Stocks rose 8.5% for the second quarter and 16.5% for the calendar year as measured by the Morningstar US Market Index.
• The leading contributors were tech giants Apple AAPL (up 17.8% for the quarter and 49.6% for the first half of the year), Microsoft MSFT (up 18.4% for the quarter and 6% for the first half), Nvidia NVDA (up 52.3% for the quarter and a whopping 189.5% for the first half), and Amazon AMZN (up 26.2% for the quarter and 55.2% for the first half).
• In 2023 through May, the top 10 stocks were responsible for 3 percentage points, or 97%, of the U.S. market’s overall 9.6 percentage-point gain. In June the concentration broadened, with stocks like Eli Lilly and Adobe also contributing to the gains.
• Nvidia’s 189.5% gain makes for the stock’s best performance in the first half of any year since the company went public in January 1999.

The above chart above shows how inflated the P/E valuations are for the top 10 stocks in the S&P 500 relative to the rest. This trend has been strong year-to-date as growth stocks have rallied. The right side shows how the market capitalization of the top 10 stocks has increased recently despite the earnings contribution remaining muted. Broader-based stock participation going forward will give us added confidence that the recent rally from the 2022 lows still has room to run.

 

DPWM OUTLOOK: A Valuation gap

In July, companies will start to report their Q2 results, which will provide fresh insights into the economy’s health. Corporate results may go a long way in signaling to investors whether the first-half rally in stock prices was warranted, or perhaps premature and deserving of some valuation adjustment.

As seen in the chart to the right, while the current valuation metric (Price-to- Earnings ratio, or P/E) for the S&P remains above its 25-yr average (currently 18.0x vs 16.0x), beneath the surface of that metric is the looming valuation difference between the largest stocks and their smaller counterparts. The upcoming earnings season could provide a catalyst to see broader participation among these smaller names if earnings calls are better than what analysts expect to be a weak earnings period.

More opportunity comes within fixed income. The rise in bond yields since last year has increased the potential returns in various fixed income sectors. We continue to favor shorter-term treasuries which not only offer yields above 5% but also provide a good ballast to equity volatility. We are not yet ready to shift significantly towards longer-term bonds, however, as we feel it may be premature due to uncertain inflation. Investors should be aware of the risk of negative real returns if nominal yields fall below inflation. Despite this, short-term investment-grade fixed income can aid in portfolio diversification and provide opportunities in riskier assets.

In the current climate, we advocate for balance and broad diversification across countries and sectors. We aim to identify mispriced risks and position ourselves to capitalize on long-term valuation differences. We anticipate a continued global economic slowdown but view a near-term recession unlikely given the strength of the labor markets and consumer spending. We do, however, remain cautious due to the effects of recent monetary policy actions and tighter credit conditions. We also acknowledge the complexity of this unconventional market cycle and the possibility of another wave of inflation. Our investment strategy is dynamic and patient, aiming to unlock long-term value.

If you would like to hear more about how we are actively navigating these markets or for more perspective on the current market environment, please don’t hesitate to call our office for a review. 720.354.3850

 

 

CITATIONS:
1. WSJ.com, June 30, 2023
2. TradingEconomics.com, June 30, 2023
3. Advantage.Factset.com, June 1, 2023
4. Advantage.Factset.com, May 26, 2023
5. CNBC.com, May 17, 2023
6. ETFDB.com, June 21, 2023
7. SectorSPDR.com, June 30, 2023
8. FederalReserve.gov, 2023
9. BureauLaborStatistics.gov, 2023
10. MSCI.com, June 30, 2023
11. MSCI.com, June 30, 2023
12. MSCI.com, June 30, 2023
13. CNBC.com, June 29, 2023
14. CNBC.com, June 2, 2023
15. WSJ.com, June 16, 2023
16. Morningstar.com, June 15, 2023
17. Reuters.com, June 20, 2023
18. CNBC.com, June 22, 2023
19. Morningstar.com, June 27, 2023
20. CNBC.com, June 13, 2023
21. MarketWatch.com, June 27, 2023
22. CNBC.com, June 14, 2023
23. JCHS.Harvard.edu, 2023
24. Zippia.com, March 12, 2023
25. PRNewswire.com, February 4, 2022
26. Wickedlocal.com, November 24, 2021 (2021 study)
27. Zippia.com, March 12, 2023
28. Kitchenbathdesign.com, March 27, 2023