Staying Invested for the Unexpected
Markets climbed higher in Q2 with US stocks now +15.9% for the year, international stocks are +9.5%, and bonds are +2.0% (1). Coming into 2023, there was plenty of pessimism around stock market returns. On November 18th, 2022, 13 Wall Street banks predicted the S&P 500 would be flat in 2023 (2). Fast forward to today, and the S&P 500 closed significantly higher than those Wall Street estimates. Those same banks are now revising their price targets higher, realizing forecasting market returns is a challenge for even the biggest banks with nearly unlimited access to information. Markets in the second quarter were driven by a tense US debt ceiling negotiation, a “skip” in interest rate hikes by the Federal Reserve, and better-than-expected corporate earnings reports.
In late May, financial media was fixated on US debt ceiling negotiations between Democrats and Republicans. The United States is one of few countries where the national debt level requires legislation outside of the country’s budget process. There were two notable debt ceiling standoffs in the past which investors used as a guide for potential impacts. The first was in 2011 which led to S&P downgrading the US credit rating one notch from AAA to AA+ and caused a -20% selloff in the stock market. However, that decline was short lived, as stocks more than recovered their losses by July of 2012 (1). The second standoff was in 2013 where the US government was shut down for 16 days. Despite government employees being furloughed, markets were resilient and had advanced +20% a year later. In 2023 while the negotiations came down to the wire, letting the debt ceiling expire was not advantageous to either party. Each party “took the wrong hostage” for the negotiations, and they ultimately passed a bill. While the US economy might have been close to a technical default, the fundamental reality is that the US is the largest economy in the world and why United States Treasury bonds are often considered the risk-free rate of return.
In June, the Federal Reserve took a pause in their restrictive monetary policy. After their June meeting, the Fed decided to “skip” raising interest rates to observe more economic data ahead of their next meeting in July. Part of their reasoning was due to a continued decline in inflation. After peaking at 8.9% in June 2022, while inflation remains far too high its reading came in at 4% in May. More encouragingly, the Federal Reserve of Cleveland forecasts inflation could be as low as be 3.2% in June. If the Fed has the patience, they can wait to ensure the lagged and variable effects of their policies are not too restrictive causing the economy to experience a recession.
Part of the reason behind the market’s rise in the second quarter was due to better-than-expected corporate earnings. According to FactSet research, 78% of companies beat their earnings expectations in the first quarter. The positive beat rate was in part because of low expectations, but nevertheless resilient earnings from technology, energy, and industrial companies outweighed low earnings from the utilities, financials, and real estate sectors. Another contributor continues to be the resilience of the US consumer. Consumer spending makes up 70% of the economy, and despite higher prices and restrictive monetary policy, the US consumer continues to plow ahead.
The top eight stocks in the S&P 500 were up an average of 75% in the first half of 2023, while the remaining 492 companies were nearly flat. This dispersion has made the top-performing stocks expensive and created opportunities to invest in other blue-chip companies. After the regional banking crisis showed signs of easing, record amounts of cash sitting on the sidelines started to buy into artificial intelligence (AI) stocks driving their share prices up significantly into what some are calling a “bubble” in those names. We believe this technology does have the potential to drive future economic growth. However, even some of the most dominant internet companies of this generation, Netflix, Apple, and Facebook, became leaders long after the invention of the internet. Therefore, we feel there is no rush to chase AI stocks as they go higher. As we alluded to in our Q1 commentary, “Proceeding with Caution”, despite a uncertain economy we remain invested for the long term because we know that missing the best 10 days in the market has a dramatic effect on investment returns (see chart below).
In the bond market, we continue to favor high-quality bonds with intermediate duration. A continuing decline in inflation, and indications that the Federal Reserve is nearing the end of their rate-hiking cycle, make bond yields the most attractive they’ve been since 2007. From interest payments alone investors can receive 5.6% in interest from investment-grade bonds with little credit risk (1). High-yield or junk bonds have done well this year as the economy fights off a recession, but we feel current yields are not pricing in enough recession risk for us to recommend adding. Preferred securities, which sit below bonds but above stocks in a company’s capital structure, offer attractive 7% interest rates. These securities faced pressure during the regional banking crisis of March, but as deposits stabilize, we see opportunities in preferreds issued by top-tier banks.
In summary, the first half of 2023 has been a pleasant surprise to investors. In investing we are humbly reminded from time to time that it is nearly impossible to predict the market. We strive to actively manage investment risk, invest in great companies, and ensure our client’s investments are aligned with their values and objectives beyond the numbers.