July 14, 2023
A Wall Street adage tells us that bull markets climb a wall of worry. The present upturn, which began in October of 2022 and has seen the S&P 500 rise over 25%, certainly fits that bill.
During the first half of 2023 financial markets defied the chorus of forecasters who anticipated that crippling interest rates would soon lead to earnings declines, recession, and investment losses. Instead, equity markets in the US, Europe and Japan delivered double-digit returns.
In the US, employment and corporate profits proved surprisingly resilient. The collapse of several large regional banks and the debt ceiling standoff in Congress put a dent in consumer confidence but did not stop households from opening their wallets. Consumer spending has also remained robust despite higher borrowing costs. Crucially, the inflation rate has fallen well below its mid-2022 peak.
The S&P 500 returned 16.9% through June, led by a handful of mega-cap tech companies riding a speculative wave of enthusiasm for artificial intelligence. Gains were more modest for the rest of the US stock market, including for value stocks and smaller companies which posted single digit gains.
Developed international markets rose +11.7% reflecting stronger than expected growth, while emerging markets gained +5.8%.
Steadying after last year’s deep bond market selloff, the Bloomberg US Aggregate Bond Index returned +2.09%. Short-term bonds and CDs are now enticing investors with yields above 5%, while longer-term investors are starting to anticipate the end of this rate-hike-cycle and a tailwind for the bond market.
Commodities prices were one of the few areas of weakness, with agricultural and hard commodity prices generally in decline.
Overall, investors enjoyed better than usual returns despite relentlessly negative media headlines.
The full effects of central bank actions take time to work their way through the system, but the 5% jump in rates since March 2022 has clearly begun to curb inflation, which dropped from 9% last summer to roughly 4% now and continues to fall.
Economic growth has slowed to a roughly 2% annual pace. Demand for workers remains strong, keeping unemployment low, but wage gains are beginning to moderate. Car prices and apartment rents have begun to level off and are expected to curb inflation further in coming months.
After a welcome pause in rate hikes in June, the Federal Reserve signaled the possibility of two more increases later this year. We expect that by 2024, inflation will be trending close to the Fed’s 2% target.
The jury is still out on whether the Fed succeeds in engineering a “soft landing” in which the economy slows without stalling, or whether we will fall into a recession.
Either way, it seems clear from manufacturing data, freight rates, commodity prices, and a host of other indicators, that while the global economy continues to grow, it is decelerating.
Regional banks are struggling to adjust to higher interest rates and could be further stressed by weakness in commercial real estate. We expect banks to tighten lending standards, adding credit scarcity to already high borrowing costs. Consumers have thus far maintained spending levels, but as COVID era surpluses are depleted, they are having to dig into savings or go into debt to fund purchases and will inevitably have to cut back.
On the plus side, job creation remains strong. Companies are enjoying good pricing power and have maintained healthy profit margins. Inflation has dropped to half what it was a year ago. The Federal Reserve is close to the end of its rate hiking cycle, and 12 months from now both interest rates and inflation will likely be lower. Looking out a little further, the emergence of generative AI and the transition to renewable energy portend a burst of innovation in technology and infrastructure that may well drive a global Supercycle the way the advent of the internet did.
As a final observation, US consumers are surprisingly circumspect considering the stronger-than-expected state of the economy. Consumer sentiment is close to its lowest levels ever despite minimal unemployment and falling inflation. According to J.P. Morgan economists, 40% of households believe we are already in a recession and 75% think we will be by the end of the year.
Generalized pessimism in the face of a resilient and still-growing economy is likely the result of political polarization, the echo chamber of social media, and wealth disparity (60% of US households report living paycheck to paycheck.) It is also a reminder that how one “feels” about the world may not be the best basis for making investment decisions. Contrarian investors have long made a lucrative practice of betting against the crowd.
Thank you for your trust. We wish you a beautiful summer.
The LongView Team