Quarterly Market Commentary – 2023 Q2

Jul 12, 2023 | Individuals, Institutions, Plan Sponsors, Quarterly Commentary

2023 Q2 Commentary: Clear as Mud

The second quarter data continue to support every market narrative – more noise and few clear signals.
The stock market extended its first quarter advance, and the S&P 500 Index in June entered a new bull market (20% above the 2022 low). With the excitement of ChatGPT and the promise of AI, the AI infrastructure stocks have led market advances. For example, NVIDIA, a dominant supplier of artificial intelligence hardware and software company has seen its stock up over 280% YTD. The stock market is focused on economic resilience.
The common wisdom of stocks, being the longest duration asset (investors look to earnings in the future), is that they tend to underperform in a rising inflation adjusted (real) interest rate environment, in a similar manner as long dated bonds. This has not been the case. For example, at the end of May, The S&P 500 was up 16.89% during the 1st 6 months of 2023. The 5 stocks that are responsible for the vast majority of the stock market’s 2023 gains are Apple (up 36% this year), Microsoft (37%), Alphabet (39%), Amazon (44%), and NVIDIA (159%). The rest of the markets have not fully participated in this bull market. One explanation is that, in a “slow or slowing” economy, investors look to technology to provide future revenue and profit. This forward looking or “looking through the near term” mentality tends to favor growth style investing. The expectation is for stocks to hold up or even expand their earnings and escape an economic contraction. June has seen some broadening market participation.
The stock market is signaling that a hopeful time is ahead, and revenue, and thus earnings, remain positive and growing.
Investors are willing to pay a higher multiple for every dollar of (projected) future earnings – a multiple expansion – which is not a sign of an economic slowdown (but a symptom of lower return choices and a low interest rate environment).
Stock investors are all about making money based on the future.
For the stock market, investors are hoping for the “immaculate disinflation” inside the wrapper of a soft landing as the likely outcome. Hawkish monetary policies are effective in falling inflation. With better financial conditions, economic expansion continues, and we are maintaining a historically low unemployment rate.
On the other hand, the U.S. treasury interest rate yield curve is and has been telling a very different story. On July 6th 2022, the 2 year/10-year U.S. treasury interest rate spread turned negative and remains negative today. Historically, this has been a signal for an impending economic contraction or recession where short-term rates (e.g., 2-year) are higher to significantly higher than long-term bond rates (e.g., 10-year).
The first interest rate increase was in March 2021, and historically, the long and variable lag is 12- to 18-months to impact the general economy. The full impact this time may be further delayed due to the massive fiscal and monetary stimuli injected into the economy. The massive fiscal transfer during the past three years ($5 trillion) muted the initial impact of tightening financial conditions (rate hikes and Quantitative Tightening) and the ramp up pace of rate hikes from 25bp per meeting to four 75bp hikes until June 2022 (12-months ago).
The fact that long-term rates are lower can be attributable to the market expecting (1) a sustained disinflation trend towards the 2% target, and thus the FOMC no longer needing to keep rates high and sooner or later will cut rates, and/or (2) a further economic slowdown towards contraction that leads the FOMC to cut interest rates to stimulate the economy.
Chair Powell has consistently and repeatedly affirmed that rates will remain elevated for a longer period of time to combat inflation and to anchor inflation expectation at 2%. Thus, there are three scenarios in which the FOMC would cut rates sooner: (1) a severe recession, (2) core inflation is convincingly reaching the 2% target level, and (3) a substantial shock to financial stability. Currently, there are no indications that any one of these conditions are present.
The bond market is focused on higher inflation and higher interest rates now with a slowing and maybe even contracting economy that further brings inflation back to its 2% target and thus leads the FOMC to cutting rates back to neutral. This is good for bonds. The Fed Fund neutral rate (R*) is likely to be 0.5% to 1% real (inflation adjusted rate). If inflation is 2.5%, the R* is likely in the range of 3% to 3.5%.