The LTWM Insider- Market and Economic Commentary Q2 2023
Executive Summary
Stocks increased in the second quarter of 2023 across all asset classes, led by tech stocks. Not enough to offset losses for the previous year and reach a new record high (last set on January 5th, 2022), but well above the lows of October 2022. There remains plenty of economic data to support either the bull or bear view for the rest of the year. The bull argument is supported by the very strong jobs market and when jobs are plentiful, U.S. consumer spending is strong. The largest tech stocks jumped in price by significant hype in the artificial intelligence (AI) sector, which may increase economic productivity or turn out to be a true bubble. The bear argument is the inevitable conclusion that the current path of rate hikes will lead to recession in the fight to bring inflation back down to 2%. Stocks tend to climb a wall of worry and the past two quarters resulted in positive stock returns.
We remain cautiously optimistic on the strength of the American consumer since jobs are still plentiful and believe corporate earnings will remain strong enough to avoid large layoffs. The investment in AI infrastructure will keep capital spending high, but its impact on productivity is still unknown and not likely to live up to the hype that drove stock prices up during the last quarter, led by the seven largest companies in the S&P 500. Not all stocks will benefit from AI and the increase in valuations during the second quarter leaves stocks vulnerable to a pullback.
For those who would like a deeper dive into the details, please continue reading…
World Asset Class 2nd Quarter 2023 Index Returns
All broad equity asset classes were positive in the second quarter, along with global bonds while U.S. bonds had negative returns. For the broad U.S. Stock Market, the second quarter return of 8.39% was well above the average quarterly return of 2.3% since January 2001. International Developed Stocks returned 3.03%, also well ahead of the long-term average quarterly return of 1.5%. Emerging Market Stocks returned 0.9%, below the average quarterly return of 2.5%. Global Real Estate Stocks returned 0.71%, below the asset class’s average quarterly return of 2.2%. The global supply chains continue functioning well, and the peak in inflation is behind us, but Q2 positive returns, on top of Q1 positive returns were still not enough to offset losses during 2022. The Federal Reserve paused raising the overnight lending rate at its last meeting, claiming the speed of rate hikes is no longer important, but is expected to raise rates another 25 to 50 basis points.
Here is a look at broad asset class returns over the past year and longer time periods (annualized):
For the full year, U.S. stocks led all broad categories with a positive return of 18.95%, International Developed stocks were close behind, up 17.41%, while Emerging Markets stocks were up only 1.75% and Global Real Estate stocks were down -3.02%. The U.S. Bond Market lost -0.94% and Global Bonds were up 1.51% for the past year. Over the past five years, U.S. stocks were up 11.39% annually, while International Developed stocks were up 4.58% annually, Emerging Market stocks were up 0.93% annually, and Global Real Estate stocks were up 1.35% annually. The U.S. Bond Market was up 0.77% annually for the past five years, while Global Bonds were up 0.95% annually. Over the past 10 years, the U.S. stock market (up 12.34% annually) is well ahead of International Developed (up 5.4% annually) and Emerging Markets (EM) stocks, which are up only 2.95% annually over the past 10 years; Real Estate stocks are up 3.8% annually, US Bonds are up 1.52% and Global Bonds are up 2.48% annually.
Taking a closer look within U.S. stocks during the second quarter, we experienced a continuation of the same theme as the first quarter, with Large Growth leading, up 12.81%, compared to Large Value, up 4.07%. The primary reason was the hype around AI tech stocks, which have inflated prices into a potentially large bubble. The valuation of tech stocks is approaching levels last seen during the internet bubble of 1999. The regional banking crisis that brought down small cap value stocks from the leading asset class to the bottom during Q1, still hasn’t dissipated and small bank stocks haven’t returned to previous values:
So far, there is no evidence of a systemic banking concern, including commercial real estate loans. We believe the vast majority of banks will make it through a period of higher default rates as lenders and borrowers negotiate new loans. The uncertain future weighs on small cap stocks, since large cap stocks are considered more defensive during challenging economic times. The Fed is still attempting to slow the economy to fight inflation through the third quarter of 2023.
If we extend our analysis of U.S. stocks over longer time periods, the strong quarter for Large Growth stocks was enough to catch Large Value stocks over the past year, 27.11% vs. 11.54%, but Large Value is ahead over three years, 14.3% vs. 13.73%. Small Value stocks lead over the past three years, up 15.43%; and then Large Growth is the top asset class over the past 5 and 10 years. The trend of value outperformance took a hit with the regional bank crisis and the current excitement of AI, which appears to be forming a tech bubble similar to 1999, when the Nasdaq hit 5000 and then needed 13 years to regain that level. It is worth noting that U.S. Market wide results for the past 10 years are very strong, up 12.34% annually.
The U.S. business cycle continues to slow by many measures, and leading economic indicators have slowed every month for the past 16 months, which could place the economy in recession at some point this year. However, the American consumer has weathered the inflation storm so far and continues to spend. We still believe it is difficult to see a heavy recession with the job market so strong. The average wage earner is doing well; and jobs are still plentiful. The U.S. job market remains very tight; and until it breaks down, we are not likely to experience a recession in the near term.
The Fed did pause from hiking rates at its last meeting but is expected to resume rate hikes in the future. We would like to see the Fed pause for a substantial period. However, the Fed will have to continue to talk tough due to the potential AI stock market bubble that increased the valuation of most large cap stocks.
Across the pond, for the second quarter, International Developed Stocks were up in local currency, but up less in U.S. dollars, since the dollar appreciated against most foreign currencies. The Euro went from $1.09 to its current value of $1.08. It is still down from $1.18 just over one year ago. The currency effect served as a small headwind to international stock returns during the quarter. The value premium (value-growth) was positive, while the size premium was negative. Our investment funds are priced in U.S. dollars (unhedged) and benefit from a weakening dollar and lose value with an appreciating dollar:
Over longer time periods, the value premium (value-growth) is positive over the past 3-year period, but still negative for 5 and 10 years. The size factor premium (small cap-large cap) is negative in the past quarter, YTD, 1-year, 3-year and 5-year periods but it is still positive over the past 10 years.
Shifting the commentary to fixed income, bond market returns around the world were positive during the second quarter, but negative in the U.S. market, due to a more aggressive Fed. The bond market is predicting two more interest rate increases by the Federal Reserve this year and the Fed’s QT (quantitative tightening) program is expected to continue for many years. The yield on the 5-year Treasury note increased by 53 basis points, ending the quarter at a yield of 4.13%. The yield on the 10-year Treasury note increased by 33 basis points, ending the quarter at a yield of 3.81%. And the 30-year Treasury bond yield increased by 18 bps to 3.85%. Here is the U.S. yield curve, and you can see how yields increased all along the curve, the highest yield on the curve is at a maturity of 6 months and the yield curve is inverted from 6 months to 10 years and flat from 10 to 30 years (current yield curve in grey, one quarter ago in blue, and one year ago in green):
Taking a look at fixed income asset classes, the highest second quarter bond return is for the US High Yield Corporate Bond Index, up 1.75%, and it now has the best 1-year return at 9.06%. The U.S. 3-Month Treasury Bill Index, up 1.17% in Q2 and up 3.59% for the past year is second best. Here are the fixed income period returns:
During the second quarter, the U.S. fixed income markets functioned well but were impacted by a more hawkish than expected Fed and yields increased, bringing bond prices down. The Fed will continue its $8.7 trillion balance sheet reduction (selling bonds) at a rate of $95 billion per month or $1.1 trillion annually. This action will keep rates at the long end of the yield curve higher than if the Fed wasn’t selling so many bonds. So far, inflation is coming down each month, but until inflation moves toward the 2% target, as gauged by the Core PCE index, the Fed’s preferred inflation measure, the Fed is going to remain hawkish. Market participants expect two more 25 basis point hikes this year, followed by what could be a long pause to assess the economic data; and then a move down at some point next year. The Fed will only lower rates when jobs look to be in trouble. Historically, stocks start a long decline after the first Fed rate drop. However, stocks can continue up with a long pause by the Fed; and especially if technology and the move to artificial intelligence (AI) improves productivity.
One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.
CONCLUSION
It is still all about inflation. However, the excitement around AI has lifted the largest companies in the S&P 500. The forward P/E multiple for the S&P 500 is 20% above the ten-year average, so stock expectations are high for future revenue and earnings. The inflation outlook is improving slowly. The labor market remains strong, consumers continue to spend, and so far, major companies are not letting go of workers.
Our recommendation, as always, is to tune out the news and focus on what you can control with your financial well-being. Please contact us with any questions or concerns. We are here to help you succeed.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2022, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2022, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2022 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2022 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
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